In foreign exchange business, hedging refers to the practice of mitigating or offsetting the risk of adverse movements in exchange rates by taking a position in a financial instrument or asset that is inversely correlated with the currency being hedged.
Hedging is typically
used by businesses that engage in international trade or have exposure to
foreign currencies. By using hedging techniques, they aim to protect their
profits and reduce the impact of currency fluctuations on their cash flows,
balance sheets, and financial performance.
There
are several methods of hedging in foreign exchange, including:
Forward
contracts: An agreement to buy or sell a currency at a
predetermined rate and date in the future, regardless of the prevailing market
rate.
Options:
A contract that gives the buyer the right, but not the obligation, to buy or
sell a currency at a predetermined rate and date in the future.
Futures
contracts: Similar to forward contracts, but traded on an
exchange and with standardized terms.
Swaps:
An agreement to exchange one currency for another at a specified rate and date,
with the exchange rate based on the prevailing market rates.