Covering Foreign Exchange Risk With the Help of Hedging Tools
Liberalization of norms on international trade has played a role of a catalyst in the economic growth of several countries. With international trade is in its boom period, the cash registers are rolling for many economies. Though liberalization is the order of the day, it has brought with it new complexities and risks that makes Forex trade a challenging task. Countries all across the globe are taking steps to minimize the foreign exchange risk to its minimum.
Foreign exchange risk is the risk that is involved when one is dealing with foreign currency, whose value keeps fluctuating with time. This fluctuation in the valuation of the foreign currency is known as foreign exchange risk. Exchange rate fluctuations can turn profitable business deals into losses. Following instruments can help you cover foreign exchange risk.
Popular Hedging Tools
- Forward Contracts: Forward contract is a contract between a buyer and seller about an underlying asset at a predetermined price, quantity and date. These contracts are flexible in nature since its terms can be changed upon the mutual consent of both the parties. However, one of the major limitations of a forward contract is that there is no established market to trade them which makes them relatively less liquid.
- Futures Contracts: Futures Contracts are the liquid forms of Forward Contracts as there are established markets to trade them. Futures contracts are bought and sold in an open market, just like shares.
- Option Contracts: An Option Contract is different from a Forwards or Futures Contract. In an Option contract, the buyer/seller of the Option has a right to buy/sell an underlying asset at a predetermined date, quantity and price, in exchange of a premium. Options are of two types – Call Options and Put Options.
One of the advantages of Options over Forward and Futures Contracts is that in case of Options, the risk to be borne by a party is limited to the extent of the premium. One can deal in the above mentioned Hedging Tools to cover foreign currency risk.
