Hedging Currency Risk

The investor can react to foreign exchange risk in one of two ways. One alternative is to do nothing. In this case, the investor is left with the foreign exchange risk and remains either the gains or losses from the currency exposure. The alternative is to hedge the risk in some way by shifting some of the risk to others. The decisions about whether to hedge or not and, if so, how much to hedge and when can be complex. The choices depend on how much volatility the investor is exposed to, how much the volatility can be reduced, how much it costs to hedge, what expectations the investor is willing to make between the reduction in volatility and the cost of the hedge.

For the investor who has decided to hedge some part of foreign exchange exposure, there are three typical hedge alternatives. The first is a symmetrical hedge using forward or futures contracts to minimize both currency gains and losses. A matched hedge uses the same currency to hedge as the investor is exposed to. A currency-basket hedge uses a portfolio of currencies to hedge the investor's exposure; the portfolio is configured in such a way as to reduce the expected hedging cost while minimizing the tracking error of the hedge.

The asymmetrical hedge uses options. The asymmetry of options is designed to preserve some gains from currency exposure while protecting against losses. The two most common option strategies are the protective put and the range forward or collar. The protective put generarlly the most expensive protection, but it preserves the majority of the gains from favourable currency exposure. The range forward (collar) is somewhat less expensive than the alternativel; it lowers the cost by capturing the gains from favourable currency exposure only up to a certain level.

The final hedge alternative consists of active management of the hedge. In this strategy, currency exposure is left unhedged when currency returns are expected to be favourable and hedged when currency returns are expected to be unfavourable. The goal of active hedge management is to capture the benefits of hedging while paying as little as possible for protection. One might think of it as trying to create the same results as a protective put while minimizing the cost of the put option. Effective active hedge management requires a systematic, on-going evaluation of potential changes in foreign exchange rates.

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