The Hedge (or Cover) is like an insurance policy; if you carry out transactions abroad, or simply if you hold foreign currency for investment purposes, a currency fluctuation can quickly cause you large losses. The hedge is a method to protect yourself against these effects: you invest in a compensation position with respect to an investment already held, so that a loss in one is offset by a gain in the other.
Steps
Method 1 of 3: Protect yourself from risk with a Currency Swap
Step 1. Swap currencies and related interest rates with a counterparty
In a currency swap, two counterparties exchange, for a predetermined period of time, a certain sum (called principal), including interest payments. Money is often generated in the form of debt (a counterparty issues a bond), or credit (a counterparty obtains a loan). The exchanged capitals are generally equivalent (for example, counterparty A exchanges with counterparty B, based on the exchange rate, $ 1,000,000 for € 750,000), while the interest rate exchanged may be different.
Here is a simple example: Vitaly Partners, an Italian company, wants to protect itself from the fluctuation risks of the euro by buying dollars. Vitaly arranges a currency swap with Brand USA, an American company. Over a 5-year period, Vitaly will send € 1,000,000 to Brand USA in exchange for the equivalent in dollars, approximately $ 1,400,000. Vitaly agrees to also exchange interest on payments with Brand USA: Vitaly will send 6% interest on its capital (€ 1,000,000), while Brand USA will send 4.5% interest on its capital ($ 1,400,000)
Step 2. Exchange the interest payments in a currency swap, not the principal
The capital that the two sides agree to exchange, in reality, is not exchanged, but is held by both sides. Capital is what is defined by financiers as "notional capital", that is, a fictitious capital that the two counterparties should exchange, but which in reality they keep. Why then is this capital necessary? Because it forms the basis for calculating the interest payable, which is the heart of a currency swap.
Step 3. Calculate your payable interest rate
The payment of the exchanged interest usually takes place every 6-12 months, and this is the moment in which the two counterparties transfer the currency, in order to protect themselves from the fluctuations of their own currency:
- Vitaly agrees to exchange € 1,000,000 at 6% with Brand USA in exchange for $ 1,400,000 at 4.5%. Let's assume that the exchange of interest payments takes place every 6 months.
- Vitaly's interest rate is calculated as follows: "Notional Capital" x "Interest Rate" x "frequency of payments". Every 6 months Vitaly will pay US Brands € 30,000 (€ 1,000,000 x 0.06 x 0.5 [or 180 days / 365 days] = € 30,000).
- The US Brand interest rate is calculated as follows: $ 1,400,000 x 0.045 x 0.5 = $ 31,500; Brand USA will pay Vitaly $ 31,500 every 6 months.
Step 4. Work with a financial credit company to deal with the Swap
The previous example, for simplicity, did not take into account a third party involved in the exchange, the banks. When Vitaly sends the interest payment to Brand USA, it does so by first sending the interest to the bank; this retains a percentage and then sends the rest to Brand USA. A similar argument applies to Brand USA; it is also necessary to mediate the transaction through the bank, which retains a percentage of their exchange for the granting of the privilege.
Step 5. Use the currency swap if you can get more favorable loan rates in your country than abroad
Why opt for currency swaps rather than simply buying foreign currency? Currency Swap involves two counterparties. Do you remember the example of Vitaly and Brand USA? Vitaly is able to obtain a more advantageous interest rate on € 1,000,000 if it applies for the loan in Italy, rather than abroad. Likewise, Brand USA manages to get a cheaper interest rate of $ 1,400,000 if they apply for the loan in the United States rather than Italy. By agreeing to exchange interest payments, the Currency Swap allows both parties to obtain more advantageous loan terms in different countries, and therefore in different currencies.
Method 2 of 3: Protect yourself from risks with Forward Contracts
Step 1. Buy forward leads
Forward contact is like a contract in the future, or a derivative; it is an agreement between two parties to buy or sell currency, on a specified future date, at a predetermined price. Here is an example:
- Dave fears the dollar is about to depreciate against the pound. He has cash at his disposal of $ 1,000,000, which would correspond to £ 600,000 in 2014. Dave wants to use a forward contract to lock the dollar against the pound. Here's what it does.
- Deve proposes to Vivian the sale, in 6 months, of $ 1,000,000 in exchange for £ 600,000. Vivian accepts the deal: it is a fixed-term contract.
Step 2. Evaluate the contact deadline and the agreed date
Let's continue with our example of the long-term contact between Dave and Vivian. In 6 months (the agreed date), three possible scenarios may occur in relation to the dollar-pound price. Each of these affects term contact:
- The dollar is rising against the pound. Suppose a dollar comes in at 0.75 pounds, instead of 0.6. Dave pays Vivian the difference between the current quote and the one agreed in the contract: ($ 1,000,000 x 0.75) - ($ 1,000,000 x 0.6) = $ 150,000.
- The value of the dollar decreases against the pound. Suppose a dollar comes in at 0.45 pounds instead of 0.6. Vivian had agreed, 6 months earlier, to pay Dave 0.6 pounds for every dollar, out of a total of one million dollars; Vivian must now pay Dave the difference between the previously agreed price and the current quote: ($ 1,000,000 x 0.6) - ($ 1,000,000 x 0.45) = $ 150,000.
- The dollar-pound exchange rate remains unchanged. The two counterparties do not make any exchanges.
Step 3. Use forward contracts to protect yourself from the ups and downs of currencies
Like a derivative, a forward contract is a great way to avoid large losses if you hold a large amount of capital in a currency and it depreciates. Here's how Dave solves this problem using a futures contract:
- If the dollar gains value, Dave is the winner, although he still has to pay something. If a dollar is worth 0.75 pounds instead of 0.6, Dave has to pay Vivian $ 150,000, but with his million dollars gold he can buy a lot more pounds.
- If the dollar depreciates, Dave hasn't lost. Keep in mind that Vivian set an exchange rate with him at the start of the contract. In this way, it is as if the dollar price never went down. Dave collects his payment, and so he's no poorer than before.
Method 3 of 3: Other options to protect yourself from risks
Step 1. Buy options on foreign currencies
Foreign currency options allow the buyer to buy or sell a specified amount of foreign currency at a specific price and on a specific date. This tool is similar to forward contracts, except for the fact that whoever holds the option is not obliged to exercise it.
In the event of favorable currency fluctuations, once the specific date indicated on the contract (called expiry date) has been reached, whoever bought the contract can exercise the option at the agreed price (called exercise price). If the currency fluctuations have made the price not convenient, the option expires without having been exercised
Step 2. Buy gold
You can also use gold or other precious metals to protect yourself from risks. Gold has been used for many years as a form of risk protection, and, even today, many investors hold it as part of their financial portfolio to protect themselves from any economic disasters.
Step 3. Change some of your national currency into a foreign currency
One of the simplest ways to protect yourself from risk is to hold foreign currency. If you live in a country that adopts the euro, for example, you can buy US dollars, Swiss francs, or Japanese yen. If the euro depreciates against other foreign currencies, having other currencies, you will be protected.
Step 4. Buy a cash contract
A cash contract is an agreement to sell or buy foreign currency at the current exchange rate and settle in 2 days. Cash contracts are essentially the opposite of futures contracts, where the deal is agreed long before the delivery of the goods (if any).
