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.