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 two days.
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 amount.
* 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 option “premium.”
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 exposure.