Types of Foreign Currency Hedging Vehicles
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 retail forex traders typically use foreign
currency options as a hedging vehicle. Banks and commercials are
more likely to use options, swaps, swaptions and other more
complex derivatives to meet their specific hedging needs.
Spot Contracts - A foreign currency contract to buy or sell at
the current foreign currency rate, requiring settlement within
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. 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.
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. 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 - A foreign currency contract to buy or sell
a foreign currency at a fixed rate for delivery on a specified
future date or period.
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.
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
* Important: Please note that forwards contracts are different
than futures contracts. Foreign currency futures contracts have
standard contract sizes, time periods, settlement procedures and
are traded on regulated exchanges throughout the world. Foreign
currency forwards contracts may have different contract sizes,
time periods and settlement procedures than futures contracts.
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 - 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). The amount the foreign
currency option buyer pays to the foreign currency option seller
for the foreign currency option contract rights is called the
A foreign currency option can be used as a foreign currency
hedge for an open position in the foreign currency spot market.
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. There are many
different foreign currency option strategies available to both
commercial and retail investors.
Interest Rate Options - 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). 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." 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 - A financial foreign currency contract
whereby the buyer and seller exchange equal initial principal
amounts of two different currencies at the spot rate. The buyer
and seller exchange fixed or floating rate interest payments in
their respective swapped currencies over the term of the
contract. At maturity, the principal amount is effectively
re-swapped at a predetermined exchange rate so that the parties
end up with their original currencies. Foreign currency swaps are
more often used by commercials as a foreign currency hedging
vehicle rather than by retail forex traders.
Interest Rate Swaps - A financial interest rate contracts
whereby the buyer and seller swap interest rate exposure over the
term of the contract. 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. Other types of swap include
fixed-to-fixed and float-to-float. Interest rate swaps are more
often utilized by commercials to re-allocate interest rate risk
John Nobile - Senior Account Executive
CFOS/FX - Online
Forex Spot and Options Brokerage
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