The following are some of the more common types of foreign currency hedging vehicles used in today’s markets as foreign currency hedges. While retail forex traders often use foreign currency options as a hedging vehicle. Banks and merchants 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 exchange rate, which requires settlement within two days.
As a currency hedging vehicle, due to the short settlement date, spot contracts are not appropriate for many currency trading and hedging strategies. Foreign currency spot contracts are most 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 why a foreign currency hedge should be placed. The spot contract is more often a part of the reason for hedging 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.
Forward currency contracts are used as a currency hedge when an investor has an obligation to make or receive a payment in foreign currency at some point in the future. If the date of the foreign currency payment and the last trade date of the foreign currency forward contract coincide, the investor has in effect “locked in” the amount of the exchange rate payment.
*Important: Please note that forward contracts are different from futures contracts. Currency futures contracts have standard contract sizes, time periods, settlement procedures, and are traded on regulated exchanges around the world. Foreign currency forward contracts may have different contract sizes, time periods, and settlement procedures than futures contracts. Forex forward contracts are considered over-the-counter (OTC) due to the fact that there is no centralized trading location and transactions take place directly between parties via telephone and online trading platforms in thousands of locations around the world.
Foreign Currency Options: A foreign currency financial contract that gives the buyer the right, but not the obligation, to buy or sell a specified foreign currency contract (the underlying) at a specified price (the strike price) on or before of a specific date (the expiration date). The amount that the buyer of the foreign currency option pays to the seller of the foreign currency option for the rights of the foreign currency option contract is called the “premium” of the option.
A foreign currency option can be used as a foreign currency hedge for an open position in the foreign currency spot market. Currency options can also be used in combination with other currency spot and option contracts to create more complex currency hedging strategies. There are many different forex option strategies available to both commercial and retail investors.
Interest Rate Options – A financial interest rate contract that gives the buyer the right, but not the obligation, to buy or sell a specified interest rate contract (the underlying) at a specified price (the strike price). ) on or before a specific date (the expiration date). The amount that the interest rate option buyer pays to the interest rate option seller for the rights to the foreign currency option contract is called the option “premium.” Interest rate option contracts are used more by interest rate speculators, traders, and banks than by retail currency traders as a currency hedging vehicle.
Foreign Currency Swaps: A foreign currency financial contract whereby the buyer and seller exchange equal initial amounts of principal of two different currencies at the spot rate. The buyer and seller exchange fixed or variable rate interest payments in their respective exchange currencies during the contract term. At maturity, the principal amount is effectively exchanged back at a predetermined exchange rate so that the parties end up with their original currencies. Currency swaps are used more by traders as a currency hedging vehicle than by retail currency traders.
Interest Rate Swaps – A financial interest rate contract whereby the buyer and seller exchange interest rate exposure during the term of the contract. The most common swap contract is the fixed-to-floating swap, in which the buyer of the swap receives a floating rate from the seller of the swap, and the seller of the swap receives a fixed rate from the buyer of the swap. Other exchange types include fixed to fixed and floating to floating. Interest rate swaps are most often used by traders to reallocate exposure to interest rate risk.