The following are some of the most common types of foreign currency hedging vehicles that are used in today’s markets as foreign currency hedging. Whereas retail forex traders often use foreign currency options as a hedging vehicle. Banks and traders are more likely to use more complex options, swaps, swaptions, and other 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 most 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 why a foreign currency hedge should be placed. The spot contract is more often a part of the reason for hedging the 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 specific future date or period.
Foreign currency forward contracts are used as a foreign currency hedge when an investor has an obligation to make or accept a foreign currency payment at some point in the future. If the date of the foreign currency payment and the last negotiation date of the foreign currency forwards contract coincide, the investor has in effect “blocked” the amount of the exchange rate payment.
* Important: note that forward contracts are different from forward contracts. Foreign currency futures contracts have standard contract sizes, time periods, settlement procedures, and are traded on regulated exchanges around the world. Foreign currency forward contracts can have different contract sizes, time periods, and settlement procedures than futures contracts. Foreign currency forward contracts are considered over the counter (OTC) due to the fact that there is no centralized business location and transactions are conducted directly between the parties via telephone and online trading platforms in thousands of locations around the world. .
Foreign Currency Options – A foreign currency financial contract that gives the buyer the right, but not the obligation, to buy or sell a specific foreign currency contract (the underlying) at a specified price (the exercise price) at or before a specific date (the expiration date). The amount that the foreign currency option buyer pays the foreign currency option seller for the rights to the foreign currency option contract 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 conjunction with other foreign currency spot and option contracts to create more complex foreign currency hedging strategies. There are many different foreign currency option strategies available to commercial and retail investors.
Interest rate options: a financial interest rate contract that gives the buyer the right, but not the obligation, to buy 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 that the interest rate option buyer pays the interest rate option seller for the rights to the foreign currency option contract is called the option “premium.” Interest rate option contracts are more frequently used by interest rate speculators, traders, and banks than by retail currency traders as a currency hedging vehicle.
Foreign Currency Swaps – A foreign currency financial contract whereby the buyer and seller exchange equal initial capital amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or variable rate interest payments in their respective currencies exchanged during the term of the contract. Upon maturity, the principal amount is effectively traded back at a predetermined exchange rate so that the parties end up with their original currencies. Currency exchanges are more often used by traders as a currency hedging vehicle rather than by retail forex traders.
Interest rate swaps: financial interest rate contracts whereby the buyer and seller exchange exposure to interest rates during the term of the contract. The most common swap contract is the fixed-to-floating 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 floating to floating. Interest rate swaps are more frequently used by merchants to reallocate exposure to interest rate risk.