Foreign currency hedging explained

Hedging may sound complicated but all it refers to is methods of trying to reduce your exposure to the various risks outlined in the other articles in this section.

There are a range of mechanisms that allow a company to hedge.

One of the most important of these is the forward contract, which removes uncertainty as to what happens in the future by fixing a price now for delivery of currency at a specified future date.

However there are some problems to be considered when it comes to forward contracts.

One such issue is that, because it is locked in, if exchange rates suddenly turn really favourable there is nothing the investor can do - he can't have his cake and eat it, as it were.

It is also for a fixed amount. More over, there can be complexities to consider such as any dividends, each of which would need to have a separate futures contract. This means paperwork, and as we all know, paperwork means more time and money is involved too!

Finally, the further into the future you wish to have maturity of the investment, the harder it is to get a rate that you consider competitive, because this market is most used for short term periods like 3 to 6 months, if there are major movements players are wary of offering anything that seems too competitive on a longer period of time basis and therefore will pro rata be more expensive to those that want them.

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