Foreign Currency
Theoretically speaking the following are some of the most common types of foreign currency hedging vehicles used in today's markets as a foreign currency hedge. While there is no denying that retail forex traders typically use foreign currency options as a hedging vehicle. On the other hand banks and commercials are more likely to use options, swaps, swaptions and other more complex derivatives to meet their specific hedging needs.
Spot Contracts These contracts can be defined as a foreign currency contract to buy or sell at the current foreign currency rate, requiring settlement within two days.
Furthermore as a foreign currency-hedging vehicle, due to the short-term settlement date, spot contracts are not appropriate for many foreign currency hedging and trading strategies. Always remember that foreign currency spot contracts are more commonly used in combination with other types of foreign currency hedging vehicles when implementing a foreign currency hedging strategy.
It is worth mentioning in this regard that for retail investors, in particular, the spot contract and its associated risk are often the underlying reason that a foreign currency hedge must be placed. In an ideal scenario the spot contract is more often a part of the reason to hedge foreign currency risk exposure rather than the foreign currency hedging solution.
Forward Contracts Forward contracts is a foreign currency contract to buy or sell a foreign currency at a fixed rate for delivery on a specified future date or period.
Theoretically speaking foreign currency forward contracts are used as a foreign currency hedge when an investor has an obligation to either make or take a foreign currency payment at some point in the future. In case if the date of the foreign currency payment and the last trading date of the foreign currency forwards contract are matched up, the investor has in effect "locked in" the exchange rate payment amount.
It is quite important to note that forwards contracts are different than futures contracts. It is worth remembering that foreign currency futures contracts have standard contract sizes, time periods, settlement procedures and is traded on regulated exchanges throughout the world. In addition foreign currency forwards contracts may have different contract sizes, time periods and settlement procedures than futures contracts. Furthermore foreign currency forwards contracts are considered over-the-counter (OTC) due to the fact that there is no centralized trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide.
Foreign Currency Options Foreign currency options is a financial foreign currency contract giving the buyer the right, but not the obligation, to purchase or sell a specific foreign currency contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). It is worth pointing that the amount the foreign currency option buyer pays to the foreign currency option seller for the foreign currency option contract rights is called the option "premium."
More often than not a foreign currency option can be used as a foreign currency hedge for an open position in the foreign currency spot market. Moreover foreign currency options can also be used in combination with other foreign currency spot and options contracts to create more complex foreign currency hedging strategies. In simple terms there are many different foreign currency option strategies available to both commercial and retail investors.
Interest Rate Options Interest rate options can be defined as a financial interest rate contract giving the buyer the right, but not the obligation, to purchase or sell a specific interest rate contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). If experts are to be believed, the amount the interest rate option buyer pays to the interest rate option seller for the foreign currency option contract rights is called the option "premium." It is worth remembering that interest rate option contracts are more often used by interest rate speculators, commercials and banks rather than by retail forex traders as a foreign currency-hedging vehicle.
Foreign Currency Swaps Foreign currency swaps is a financial foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. In addition the buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. Furthermore at maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. In theory foreign currency swaps are more often used by commercials as a foreign currency hedging vehicle rather than by retail forex traders.
Interest Rate Swaps Interest rate swaps can be termed as a financial interest rate contracts whereby the buyer and seller swap interest rate exposure over the term of the contract. As a matter of fact the most common swap contract is the fixed-to-float swap whereby the swap buyer receives a floating rate from the swap seller, and the swap seller receives a fixed rate from the swap buyer. Furthermore other types of swap include fixed-to-fixed and float-to-float. It is worth pointing that interest rate swaps are more often utilized by commercials to re-allocate interest rate risk exposure.
There is no denying that the prevailing exchange rate of a foreign currency is one of the most sought-after financial figures by exporters, importers, investors, tourists or even ordinary citizens who have several dollars towed away somewhere in the privacy of their homes. Fact remained that even the ordinary citizens outside the United States hold on to their precious dollars hoping for an increase in the foreign currency exchange rate later on.
In an ideal scenario foreign currency exchange rate refers to the value of a certain currency based or compared to the rate of another currency. It is worth noting that the value of the dollar for example is often used as the standard peg of most currencies in the third world. Always remember that a foreign currency exchange is said to be increasing its value if it is gaining strength against the dollar even in terms of centavos.
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