Risk hedging is a transaction of protecting an already existing or expected position from sudden price fluctuations of exchange rates. By using risk hedging properly you will be secure from market going up or down.
Therefore, hedging can be simply understood as a prior protection against expected and unexpected changes in exchange rates. It is used primarily by investors, traders and business owners to eliminate investment risk.
The Benefits of Hedging
Hedging is accomplished by different methods ranging from basic to extremely intricate mechanisms. However the goal is one: to eliminate the risk. It requires purchase of a second asset which is in negative correlation with the first one. So that once your hedged security does not move according to your expectation the loss is minimized.
Here, it is important to pay attention to the fact that hedging is not a way of making profit per se; it aims at removing uncertainty, through reducing unexpected and unfavorable risks.
Risk reduction always presupposes profit reduction – hedging mainly represents a technique by which one can reduce losses but may not make money. An expected profit in case of hedging is lower than in case of not hedging, conversely, in case of sustaining losses – your hedge will reduce the extent of loss.
The first step would be to consider the level of risk and potential foreign exchange exposure, and only then decide what actions to take to mitigate that risk.
Spread Trading as a Popular Way of Risk Hedging
One of the popular methods of risk hedging is spread trading. The concept of spread trading is the simultaneous buying or selling two assets with the expectation that their prices will converge. In other words it suggests opening an opposite position in other security to mitigate the risk. So that in case you have opened a short position and want to reduce the upside risk you should open a long position with another asset. And the opposite procedure will take place if you have opened a long position.