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A foreign exchange hedge transfers the foreign exchange risk from the trading or investing company to a business that carries the risk, such as a bank. There is a cost to the company for setting up a hedge. By setting up a hedge, the company also forgoes any profit if the movement in the exchange rate would be favourable to it.
Currency risk: the risk that a financial instrument or business transaction will be affected unfavorably by a change in exchange rates. Foreign exchange risk hedging [15] [16] is used both by investors to deflect the risks they encounter when investing abroad, and by non-financial actors in the global economy for whom multi-currency activities ...
Firms with exposure to foreign-exchange risk may use a number of hedging strategies to reduce that risk. Transaction exposure can be reduced either with the use of money markets , foreign exchange derivatives —such as forward contracts , options , futures contracts , and swaps —or with operational techniques such as currency invoicing ...
Managing balance sheet risk can involve organic (natural) hedging such as using cash positions or intercompany loans to create exposure offsets. It can also involve external hedging such as buying a forward contract to offset FX exposure. See Foreign exchange hedge and Foreign exchange derivative § Instruments.
A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rates of two (or more) currencies. These instruments are commonly used for currency speculation and arbitrage or for hedging foreign exchange risk .
A specific type of hedging transaction that entities can engage in aims to manage foreign currency exposure. These hedges are undertaken for the economic aim of reducing potential loss from fluctuations in foreign exchange rates. However, not all hedges are designated for special accounting treatment.
Investors use these futures contracts to hedge against foreign exchange risk. If an investor will receive a cashflow denominated in a foreign currency on some future date, that investor can lock in the current exchange rate by entering into an offsetting currency futures position that expires on the date of the cashflow.
It is mainly used for trading in foreign currencies, where the contracts are used to hedge against foreign exchange risk. [1] [2] Commodities are also traded on forward markets. Examples include agricultural products such as rice, [3] and energy futures, such as oil and natural gas.