When most people think about the Forex market, their minds jump to the ins and outs of trading currencies. And, while it is possible to make money by trading currencies on the FX market, it is important to note that the currency market has other purposes as well. The savvy money manager can hedge different currency risks with the help of the Forex market, whether those risks come from your income, or whether they come from global investments denominated in various currencies.
If you work for a global company, work as a contractor, or live in a foreign country, you might find that your salary is in a currency that differs from the currency that you use for spending money. If you work for an American company, and receive your salary in dollars, but live in Japan and so do most of your spending in yen, you can find that changes in the currency rate can mean a de facto raise – or pay cut.
If the exchange rate for USD/JPY is 77.00. That means that if you expect a salary of $10,000 a month, you would receive 770,000 yen. However, if the exchange rate drops, even a little, to 76.00, you would end up with only 760,000 yen for the month. Your employer didn’t pay you less, but the exchange rate reduced your spending power by 10,000 yen.
In order to hedge against such a loss, you could open a position at the beginning of the month, shorting USD/JPY. You wouldn’t even need to open a huge position. One pip of a mini-lot of the yen is 100. So, the exchange rate drops, the dollar falling against the yen, if you are shorting USD/JPY, results in a Forex market gain of 10,000, offsetting the difference between 770,000 yen and 760,000 yen. (If USD/JPY rises to 78.00 instead, you will lose 10,000 on the Forex market, but your gain in purchasing power, to 780,000 yen, will mean there is no net loss overall.)
The main thing to remember when hedging currency risks from your income is to go long on the currency you spend in, and short the currency you earn in. So, if you live in the eurozone, but earn money in dollars, you would go long on the EUR/USD currency pair. And, conversely, if you are earning in euros and living in the US, you would want to short EUR/USD.
You should also understand that hedging is not about making money in the Forex market; it’s about limiting losses to your spending power due to changes in the currency exchange rate. This means that you should close out your position each month, book your profit or loss, and then immediately reopen the position. Keep in mind that the point is to prevent income losses from a depreciating currency, and the nature of the hedge means that you won’t see profits.
You can also use a similar strategy to hedge your exchange risk related to foreign investments. If you invest in foreign markets, using differently-denominated currencies, you run the risk of seeing your returns dragged down by a depreciating currency, or seeing your losses multiplied. For example, if you invest in a foreign fund following the FTSE 100 index and the pound loses value relative to the US dollar, then your conversion to US dollars means that your earnings from the FTSE 100 will be reduced. If the FTSE 100 drops during this time, your losses will be magnified by the depreciating currency.
You can use the Forex market to hedge against this type of risk. If you are worried about another currency depreciating, you can short it. If you are getting ready to sell some of your shares in the FTSE 100 fund, and you are worried that a falling pound could be a problem, you can short GBP/USD. That way, when sterling does drop, you can use the profits to offset losses from the investment. This strategy can work with a number of investments, including commodities and real estate.
Any time you are concerned that a changing exchange rate could result in currency risks, whether it involves a reduction to spending power, or investment losses, you can use the Forex market to hedge your risks. Even if you still book net losses, a hedging strategy can help your limit your losses so that they aren’t as large.