FOREX Hedging Methods

• Foreign exchange risk relates to adverse currency rate movements that affect your bottom line. When buying overseas goods, you lose purchasing power as domestic currency values decline. When selling goods overseas, however, your business becomes less competitive when domestic currency rates strengthen and increase prices for foreign buyers. FOREX hedging methods, such as diversification, derivatives, and currency swaps, are designed to improve profitability and manage the risks of transacting international business.

Diversification

• Diversification is an investment strategy that allows you to profit across various economic scenarios. In terms of foreign exchange, you may hold both Russian rubles and U.S. dollars as part of a diversified currency portfolio. When energy prices increase, the U.S. economy and dollar typically decline. At the same time, the ruble should appreciate in value -- because Russia is a large exporter of oil and natural gas.

  Large corporations, such as Nike and Coca Cola, expand overseas to diversify and hedge their foreign exchange exposure. As a smaller investor, you may purchase shares of stock within these multinational corporations for diversification. Further, shares within international mutual funds carry rights over hundreds of different global securities, which would also help meet your diversification objectives.

Currency Derivatives

• Currency derivatives, such as options, futures, and forwards, allow sophisticated investors to lock in currency rates and hedge financial risks. Options and futures contracts trade on organized exchanges, such as the New York Mercantile Exchange. For a premium expense, options grant you the choice to receive or deliver currency at a set exchange rate at a later date. Futures, however, are binding agreements that enforce execution at set exchange rates. Options and futures are relatively liquid arrangements because they do trade on organized exchanges. This means that these derivatives can easily be bought and sold for cash.

  Forwards, however, are private agreements between two parties to trade currency at set rates into the future. Forwards allow for high levels of customization but do not trade on organized exchanges. A forward agreement would therefore be difficult to exit and raise cash.

Currency Swaps

• Swaps are essentially agreements for separate institutions to pay each other's bills. Currency swaps feature two parties that exchange payments in different currencies. When transacting international business, currency swaps are often combined with interest rate swaps to manage the international interest rate environment. With interest rate swaps, one party agrees to make payments at fixed rates, while the other makes payments at floating rates. Swaps are especially important hedging tools for overseas lenders and borrowers. For example, a bank that loans money out in yen may enter into swaps to effectively establish set exchange and interest rates for the yen principal repayment.