Forex Trading for Hedging and Speculation
The fundamental reason organisations use foreign exchange is not to buy or sell physical goods but for risk management. Foreign currency can change drastically over time. Those who may be affected by these fluctuations such as investment banks, fund managers and corporations, can use the foreign exchange markets to protect themselves from this uncertainty of price enabling risk to be transferred from those exposed to risk, to those seeking to benefit from the risk. The foreign exchange market is therefore a risk shifting mechanism, enabling those exposed to these risks to shift them to someone else.
Overall businesses, financial institutions, commodity producers and any market participant with risk of price movements are able to use foreign exchange markets to minimise their risk, lower the cost of doing business and ultimately pass on price savings to the end consumer. Broadly speaking, foreign exchange can be used for hedging or trading (speculation) purposes.
Buying and selling foreign exchange as a risk management tool is called hedging. Hedging means to cover a foreign exchange exposure through an offsetting transaction. This is also known as ‘cover’. Cover is usually obtained by using forward contracts. Forward exchange rates are widely used by importers, exporters, borrowers and investors for the purpose of hedging.
FX enables participants to hedge or protect the value of their currency against the risk of price fluctuations in another currency by taking a position in the foreign exchange market opposite to the physical position they hold to benefit from the adverse price movement. By using foreign exchange, participants are able to lock in a fixed buying or selling price and any profits or losses that arise from their foreign exchange position will offset any losses and gains in the physical market.
For example, importers are generally required to pay the foreign exchange suppliers in foreign currency. An example is, when Australian importer buys cars from Japan. They have an exchange rate exposure upon committing to pay the supplier a fixed amount of Japanese Yen. The lower the exchange rate of the Australian Dollar (AUD) against the Japanese Yen at the time the importer purchases the fixed amount of Yen, the greater will be the cost in AUD. The importer can hedge their exposure by using the forward exchange market to purchase the Yen before the exchange rate falls. Once hedged, the importer knows their AUD exposure and has also eliminated the exposure to exchange rate movements.
Speculating is the practice of buying and selling currency to make a profit. Speculators enter the foreign exchange market, buying and selling in anticipation of future price movements. A speculator has no desire to actually own the physical currency. The speculator assumes market price risk, adding liquidity and capital to the foreign exchange markets. While they put their money at risk, they won’t do so without first trying to determine to the best of their ability whether prices are moving up or down.
Speculators analyse the market and forecast foreign exchange price movement as best they can. They may engage in the study of the external events that affect price movement or apply historical price movement patterns to the current market. In any case, the smart speculator doesn’t operate blind. A speculator who anticipates upward price movement would want to take advantage by buying that parcel of foreign currency. If predictions are correct, then the parcel of currency can be sold later at a profit. If it’s expected that prices were going to move downward, the speculator would want to sell now and, if all goes as planned, buy back later at a lower price.