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What is Currency Hedging?

Malcolm Tatum

Last Modified Date: January 27, 2024

Currency hedging is an approach that is intended to manage the degree of risk that may be present when engaging in some type of foreign investment strategy. Essentially, the structure of a currency hedging process would attempt to compensate for any shifts in the relative value of the currency type utilized in the investment scheme. The hope is that by minimizing the exposure of the investor to unfavorable shifts in the money market, a reasonable return on the investment will be achieved even if the currency involved takes a fall.

In general, any hedging strategy is understood to help insulate the investor from the occurrence of events that could threaten to cause a deal to lose money. When it comes to currency hedging, the idea is to convert or exchange the currency while the rate of exchange is favorable, and then make the investment with currency that is native to the country of origin where the investment is based. For example, rather than paying for shares of stock connected to a company based in the United Kingdom with United States dollars, the investor would first convert the dollars into British pounds, then use the pounds to make the actual stock purchase.

In order to further protect from possible changes in the rate of exchange, the investor normally will also agree to sell shares after a given time period. The shares would be sold at a rate that may be slightly below the exchange rate between the pound and the dollar that was in effect prior to the purchase of the shares. What this does is create a situation where the investor stands to make a substantial profit if the dollar actually strengthens against the pound in the interim. At the same time, if the dollar weakens against the pound during this period, the loss is offset by the contract to sell the shares, thus minimizing the overall lost that must be absorbed by the investor. In this manner, currency hedging functions as a level of protection for the investor.

The use of currency hedging strategies is a great way to keep the amount of loss at a minimum when dealing with international investment opportunities. At the same time, the approach does not in any way cripple the ability to make a substantial profit from the venture. By employing this approach, it is possible to entertain investment opportunities that would otherwise be considered too volatile for the investor to consider.

After many years in the teleconferencing industry, Michael decided to embrace his passion for trivia, research, and writing by becoming a full-time freelance writer. Since then, he has contributed articles to a variety of print and online publications, including SmartCapitalMind, and his work has also appeared in poetry collections, devotional anthologies, and several newspapers. Malcolm’s other interests include collecting vinyl records, minor league baseball, and cycling.

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Discussion Comments

summertime

November 9, 2010

I am on the other side of the fence compared to the two previous comments. There seems to me that a great need of financial protection needs to be implemented for the exact reason of thwarting a major financial meltdown like the previous ones in history that we have experienced. Currency hedging does just that, it provides a layer of protection for investors that are trading in currency and cash flow.

This means of protection is especially important when dealing with foreign currency hedge issues. Only when our world comes together enough to agree on a single financial system will the perils of foreign currency trading cease to exist because we will have completely converted over to a universal currency in which anyone can be assured of the value, no matter what your geographic or socioeconomic status is.

This is true freedom people. The ability to trade in a universal fashion that is uninhibited by tariffs, taxes and other risks to products, services and currency.

MrPolitic99

November 9, 2010

When it comes down to it, there is really not much difference in the basic principles of investing on the stock market and gambling in a casino. Even with currency hedging and other means of buffering an investor from risks when cash trading, there is always a way for the house to win. Don't think that big banks just make financial deals so you can start a new business, they always will have a hand in it to try and make money off of anything that they touch. That is after all, their main goal.

Banks make money and they make that money off of you. Once we realize that simple truth then we can look beyond things like currency hedging and how to hedge currency and look into real ways to stimulate our economy where everyone actually grows a bigger bottom line and balance in their account.

fitness234

November 9, 2010

The problem with currency hedging and other forms of currency risk analysis is that it is so much based on crazy formulas and not real world sense. This kind of market based research can leave investors and others blind to the actual happenings in the world that will greatly affect how they do in market economy. Currency hedging options have gotten so out of hand that it is a concern that the national government should look into and determine if some kind of oversight or regulatory body should be tasked with researching the subject.

Only when we create concise and sensible economic policies will we be able to break away from disastrous actions that have cause our great money meltdowns in history. I hope for the sake of our children that we figure it out soon or they will be paying for it for years to come and possibly even their grandchildren will feel some effect of our misguided action.