The forex rates are dependent upon a number of micro and macro factors. Some of these factors are controllable whereas most of these are uncontrollable by the traders and investors at large.  

Such factors the outcome of which are beyond the control of the trading fraternity needs to be hedged. What is hedging? Hedging is the scientific method of protecting against the risk of losing money because of change in forex rates over a period.  

How to hedge? 

In hedging the individual/trader/manufacturer/organization enter into a contract with a third party where the third party agrees to bear the difference of the forex rate as agreed. In return for bearing this risk the third party charges a commission on the entire deal. 

During the period for which the contract has been entered into, the first party (hedger) is safe from any movement in the forex rate which could be detrimental to the business of the company. For ensuring this protection the first party has to bear some fixed expenses. 

Then why would the third party take up such a risk. Simple. It would do so because it is in the business of taking such risks. Any movement in the forex rate otherwise would benefit the third party. Let us understand through a hypothesis example: 

Party A belongs to Europe and exports to America 

Trading rate of forex Euro: USD on 10^th July 2007 is 1.25 which means that for every USD received a person can purchase Euro 0.80 

The party A is on the opinion that after 3 months when it would be receiving its billed amount for the services offered to the US client the forex rate for Euro : USD would be around 1.50 which means that for every USD it receives it would have Euro 0.67 (after conversion into its national currency of Euro). Effectively it would mean lower conversion rates into its currency (euro). In order to ensure that it is not caught off guard and ends up having lower revenues than expected it would hedge its position in the market against such movements for a fixed charge on the entire hedging amount. 

Now for the third party who has entered into the hedging contract with the party A it would mean running the risk of losing amount equivalent to the difference of the hedging rate and the actual rate at the time of honoring of the contract. But risk as they say also brings with itself the possibility of earning. The third party stands the chance of pocketing the entire hedging charge as profits if the forex rate remains stable or the Euro depreciates against the USD or the USD appreciates against the Euro.

No Comments Yet.