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Hedging (Essay Sample)


The essay defines and expounds on the phrase currency Hedging.

Currency hedging can be defined as an act of engaging in financial contracts to provision against losses anticipated from deviations in currency exchange rates. It is a financial strategy used by investors or businesses to reduce the level of risk when performing transactions internationally. Currency hedging resembles an insurance policy put in place to reduce negative outcomes of foreign exchange risks. The concept attempts to minimize the exposure of an investor to unfavorable changes in money market. This is in an attempt to guarantee that a size-able return on investment can be obtained even though currency value falls.
International trade has tremendously grown over time because of inventions of remarkable trading tools such as the internet. This has increased the transparency of trade in international markets. At the same time, international politics and economic factors have elevated uncertainties of foreign exchange rates. This has amplified international markets volatility and the need for currency hedging. Hedging ensures that entities have a growing concern even after contingencies occur due to fluctuations in foreign exchange rates. In hedging, investors seek to exchange currencies when their market value is still favorable. There are various forms of currency hedging that an international investor can use.
Option hedging is the most common and widely used form of hedging. It is rated to be the best form of hedging by numerous investors across the globe. It can be characterized as a trading privilege transferred to the ownerCITATION DrK13 \l 1033 (McNew). This means that a trader can purchase or sell his assets in the future market at a specified price. Exchange-traded options were first used in 1937. Over the years, their popularity has tremendously increased. Some traders have been shy to use options out of believes that they are sophisticated and hard to understand. However, when used well, they have numerous advantages. First, they are cost efficient. Options give investors an immense leveraging power. An investor is able to control potential losses without creating a limit to potential gains.
Options are also less risky depending on how they are utilized. Options do not require an intensive financial commitment unlike equities. A large proportion of operating capital is not tied up in hedging operations. They are also impervious to the potential negative effects of gap opening. Options are dependable, and thus safer than stocks. Options offer higher potential returns from a current investment than any other form of hedging. An investor can spend a small amount of funds in provisioning for risk, and obtain a profit which is almost equivalent to the invested amount. This translates into a high percentage of returns to an investor in terms of profits.
When using options, an investor has more strategic investment alternatives. This is because options are very flexible investment tools. Options can be committed to recreate synthetic positions. These positions are representations of investors who have multiple strategies to attain the same investment goals. Options can be extremely beneficial to investors if used wisely. However, they have several disadvantages. First, they cannot offer a full hedge in an investment. Their coverage is partial. At the same time, they can be subjected to basis risk. Options are only drafted for fixed or specified amounts and values. Thus they do not have much liquidity.
The second form of a hedge, is hedging with future contracts. Future contracts in ...
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