Thursday, May 30, 2024

Risk versus reward: The FX hedging risks you need to know inside-out

There’s no doubt that forex has become a lot more mainstream over the years. While it might have appeared like some sort of foreign term several years ago, now the basics are at least understood by the Average Joe.

However, whether or not that same Average Joe would be able to identify the various hedging risks associated with this is another matter. In truth, this is a volatile form of trading, and this is one of the reasons hedging currency companies are so in-demand.

Following on from the above, let’s now look at some of the big risks that apply to this type of trading.

Interest rate risks

This first risk really shouldn’t come as a surprise to any reader. After all, pretty much everyone in the world is affected by interest rates in some shape or form. For the typical person they can affect their mortgage rate – and similar rules apply in the world of Forex.

The issue with interest rates is that a rise in them causes a currency to strengthen. At the same time, as soon as they start to drop, the currency weakens. This all relates to how investors are treating a country’s assets.

There is a distinct correlation between forex prices and interest rates. As such, if there is anything in the media suggesting that an interest rate might be about to change, this will impact your forex investments as well.

Transaction risks

This next risk is a little more unknown, so to speak, as it only really applies to the world of trading.

As we all know, trading is performed across the world. As we also all know, different countries in the world operate in different time zones.

However, if we hone in Forex, this is something that occurs on a 24-hour cycle. In other words, it never closes. This means that the exchange rate can change before a trade has settled.

Country risks

This is applicable to most investments, but with Forex it is particularly relevant. In short, there is a lot of risk associated with those so-called weaker countries. Most developing countries will fix their exchange rate with the US dollar. However, in doing this, their own central banks need to keep sufficient reserves of dollars to keep this exchange rate. If payment deficits start to occur, the currency will immediately start to devalue.

Unfortunately, this is a problem that simply snowballs. In other words, as soon as an investor starts to hear that a currency is weakening, and ultimately decreasing in value, they might start to withdraw their assets from the country. This simply enhances the problem, and means that the currency keeps on getting weaker.

This is something that isn’t completely theoretical either. These sorts of problems have occurred in some established financial markets and one only has to look at the Asian Financial Crisis, and even the Argentine Crisis, which have both resulted in home currencies falling apart.

Elliot is the Editor at ABCMoney. He manages a team that writes and contributes to many leading publications across a number of industries.

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