The following are some of the most common types of foreign currency hedging instruments used in the market today as foreign exchange hedges. Meanwhile, retail forex traders usually use forex options as a hedge. Banks and trading firms are more likely to use options, swaps, swaps and other more complex derivatives for their hedging needs.
Spot Contract – a foreign currency contract to buy or sell at the current foreign exchange rate, and requires settlement within two days.
As a forex hedging instrument, due to its short settlement date, spot contracts are not suitable for many forex hedging and trading strategies. Foreign currency spot contracts are more commonly used in combination with other types of foreign currency hedging instruments when implementing a foreign currency hedging strategy.
Especially for retail investors, spot contracts and the risks associated with them are often the main reason why forex hedging should be undertaken. Spot contracts are often the reason to hedge foreign currency exposure rather than foreign currency hedging solutions.
Forward contract – a foreign currency contract to buy or sell foreign currency at a fixed rate for delivery at a specified date or period in the future.
A foreign currency forward contract is used as a foreign currency hedge when the investor is obligated to make or collect payments in a foreign currency at some time in the future. If the foreign currency payment date and the last trade date of the foreign currency forward contract match, the investor is effectively “locked in” to the payment amount based on the exchange rate.
*Important: Please note that a forward contract is different from a forward contract. Foreign exchange futures contracts have standard contract sizes, terms, and settlement procedures and are traded on regulated exchanges throughout the world. Foreign exchange futures contracts may have different contract sizes, terms and settlement procedures than futures contracts. Foreign exchange futures contracts are considered over-the-counter (OTC) because there is no central trading location and transactions are conducted directly between parties via telephone and online trading platforms in thousands of locations worldwide.
Foreign Currency Option – A financial contract in a foreign currency that gives the buyer the right, but not the obligation, to buy or sell a specified foreign currency contract (underlying) at a specified price (strike price) on or before a specified time period. date (expiry date). The amount paid by the buyer of a foreign currency option to the seller of the foreign currency option for the rights to the foreign currency option contract is called the option “premium”.
Foreign currency options can be used as a foreign currency hedge for open positions in the spot foreign exchange market. Foreign currency options can also be used in conjunction with forex contracts and other options to create more complex foreign currency hedging strategies. There are many different forex options strategies available to commercial and individual investors.
Interest rate option – a financial interest rate contract that gives the buyer the right, but not the obligation, to buy or sell a specified interest rate contract (the underlying) at a specified price (the strike price) on or before a specified date (the expiration date). The amount paid by the buyer of an interest rate option to the seller of the interest rate option for the rights to the foreign currency option contract is called the option 'premium'. Interest rate options contracts are used more frequently by interest rate speculators, trading firms and banks than by retail forex traders as a foreign currency hedging tool.
Foreign exchange swap – a financial contract in a foreign currency in which a buyer and seller exchange the same principal amount of two different currencies at the spot rate. Buyers and sellers exchange fixed or variable interest payments in their respective currencies over the term of the contract. At maturity, the actual principal amount is exchanged at a predetermined exchange rate so that both parties get the original currency. FX swaps are more frequently used by commercial companies as a foreign currency hedging tool than by retail forex dealers.
Interest rate swap – a financial interest rate contract in which a buyer and seller exchange interest rate exposure over the term of the contract. The most common swap contract is a fixed-to-floating swap contract in which the swap buyer receives a floating interest rate from the swap seller, and the swap seller receives a fixed interest rate from the swap buyer. Other swap types include fixed-to-fix and float-to-float. Interest rate swaps are often used by commercial companies to reallocate exposure to interest rate risk.
