Currency hedging: what is it, how does it work and what are the types?

Understand what currency hedging is and how this financial market operation works

Currency hedging is a strategy designed to protect investments.

In fact, this set of instruments used to protect investments is also useful for importing and exporting companies and even for tourists who want to travel to another country.

And if you want to know how this works in practice, read on. We'll explain everything about it.

What is a currency hedge?

Currency hedging is a financial market operation that protects the investments of individuals and companies.

In other words, these financial instrumentsThis reduces the risks related to operations with two or more different currencies.

Therefore, we can say that the purpose is not exactly to generate profits, but rather to reduce future uncertainties.

In times of financial crises, it is common for emerging country currencies, such as the Brazilian real, to lose value against stronger and more stable currencies.

This is because investors are starting to look for safer assets, like the dollar, driving up prices.

The exchange rate is susceptible to the macroeconomic environment and can fluctuate frequently (even daily).

Therefore, anyone who makes financial transactions with currencies needs to understand this operation very well and create a strategy.

How does currency hedging work?

As you already know, currency hedging is a defense mechanism to protect an investor's assets from exchange rate fluctuations.

It can happen in a variety of ways, but the most common practice is trading on the futures market.

The futures market is the environment in which futures contracts are traded.

Participants commit to buy or sell a certain quantity of an asset for a stipulated amount for settlement at a future date.

But the difference is that on the futures market, prices are adjusted on a daily basis.

On the stock exchange, contracts are standardized.

What are the types of currency hedge?

Now that you know what a currency hedge is, it's time to learn about the main types:

Futures contract

As you already know, this is the most commonly used type.

The futures market protects producers and investors from asset price volatility.

However, it is also widely used by speculators who want to profit from these operations.

The buyer and seller will decide in advance on the future value of the currency derivative and the maturity date.

Regardless of the value the asset may reach in the future, the price was set beforehand, i.e. during trading.

It is worth mentioning that in this market, it is possible to obtain results with both positive and negative fluctuations in the price of a specific contract.

Currency SWAP

Currency SWAP is a term used to refer to the process of exchanging foreign currencies.

It can be translated from English into Portuguese as an exchange.

As such, it is an exchange of indexes carried out to manage adjustment rates and control the exchange rate.

The company interested in hedging will acquire the right to buy dollars at the current rate. However, the purchase will take place within the maturity of the exchange-indexed contract.

The financial institution, on the other hand, will guarantee the exchange rate for the buyer. In other words, it will deal with the risk of exchange rate fluctuations.

Both companies and financial institutions want to protect themselves from the devaluation of the real against the dollar.

The Central Bank, on the other hand, wants to keep the exchange rate stable.

In times of crisis, it is normal for the value of the dollar to rise considerably over a short period.

In these situations, the Central Bank engages in swap operations, intervening in the dollar in order to prevent the real from devaluing further.

International cash flow

Companies operating in foreign trade can use their foreign exchange cash flow to escape the fluctuations.

Moreover, in the case of institutions operating in different countries, maintaining an international cash flow acts as a natural hedge.

In this way, the dollar can be used to carry out commercial transactions, such as payments for services and imports of certain products.

But for this to happen, the company in question needs to have a bank account abroad or an exchange account.

When is currency hedging worthwhile?

This operation can bring benefits when the aim is to carry out financial operations that are exposed to the risks of exchange rate variations.

For companies operating abroad, protecting themselves from exchange rate fluctuations is a way of ensuring a profit margin without surprises.

For ordinary investors, the practice may or may not be advantageous. In this case, you need to have a lot of knowledge about the market and the assets. That way, you can determine whether hedging really is a good option.

In times of crisis, the demand for hedging operations increases significantly.

What do you need to do a currency hedge?

The first step is to open an account with a stock broker.

Then you have to choose the best protection instrument.

Are you an investor and want to protect your assets from a possible devaluation of the real? Or are you an importer worried about a possible rise in the dollar?

Before making a decision, you need to consider all the options available and the costs involved.

Conclusion

As you can see throughout this post, currency hedging is an advantageous protection mechanism for investors, transactions and international business.

Over all this time, hedging has evolved and been adopted by the financial market and used for various purposes.

If you think that currency hedging is a good strategy to protect your investments, you need to evaluate the options and costs of each tool.

As complicated as it may sound, if you or your business work with currencies from other countries, currency hedging is a good option to escape exchange rate variations which, in many situations, occur over a very short period of time.