What is currency hedging?

Currency hedging is an approach aimed at managing the degree of risk that may be present when engaging in some type of foreign investment strategy. Essentially, the structure of a currency hedging process would attempt to offset any changes in the relative value of the type of currency used in the investment scheme. The hope is that by minimizing the investor's exposure to unfavorable changes in the money market, a reasonable return on investment will be achieved even if the currency involved falls.

It is generally understood that any hedging strategy helps to insulate the investor from the occurrence of events that could threaten to make a business lose money. When it comes to currency hedging, the idea is to convert or exchange currency while the exchange rate is favorable and then make the investment with the native currency of the home country where the investment is based. For example, instead of paying for shares linked to a UK-based company with US dollars, the investor would first convert the dollars into sterling and then use the pounds to purchase the shares.

To further protect themselves from possible changes in the exchange rate, the investor normally also agrees to sell shares after a certain period of time. The shares would sell at a rate that could be slightly lower than the pound-dollar exchange rate that was in effect prior to the purchase of the shares. What this does is create a situation where the investor can make a substantial profit if the dollar actually strengthens against the pound in the meantime. At the same time, if the dollar weakens against the pound during this period, the loss is offset by the contract to sell the shares, thus minimizing the overall loss that must be absorbed by the investor. In this way, the currency hedge works as a level of protection for the investor.

Using currency hedging strategies is a great way to keep the amount of loss to a minimum when it comes to international investment opportunities. At the same time, the approach does not in any way affect the company's ability to make a substantial profit. By employing this approach, it is possible to entertain investment opportunities that would otherwise be considered too volatile for the investor to consider.

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