Forex: Hedging Against An Asset

The fact that exchange rates can change makes people take different views of foreign currencies.

Some people do not want to have to gamble on what exchange rates will hold in the future, and want to keep their assets in their home currency alone. Others, thinking they have a good idea what will happen to exchange rates, would be quite willing to gamble by holding a 'foreign' currency', one different from the currency in which they will ultimately buy buy consumer goods and services. These two attitudes have been personified into the concepts of hedgers and speculators, as though individual persons were always one or the other, even though the same person can choose to behave like a hedger in some cases, and at times, like a speculator in others.

Hedging against an asset, here, a currency, is the act of making sure that you have neither a net asset or a liability position in that asset. We usually think of hedgers in international dealings as persons as who have a home currency and insist on having an exact balance between their liabilities and assets in foreign currencies.

In financial jargon, hedging means avoiding both kinds of 'open' positions in a foreign currency --- both 'long' positions, or holding net assets in the foreign currency; and 'short' positions, or owing more of the foreign currency that one holds. For example, an American who has hedged his position in West German marks has assured that the future of the exchange rate between dollars and marks will not affect his net worth.

The foreign exchange market provides a useful service to hedgers by allowing hedgers of all nationalities to get rid of net asset or net liability positions in their respective foreign currencies.

Suppose, for example, that you are managing the financial assets of a American pop group, and that the group has just received 100,000 British pounds in checking deposits in London as a result of selling its records in Britain. The group wants to hold onto the extra money in some form for a while, say, for three months. But doing so exposes the group to an exchange-rate risk. Take this as an example: the value of each pound sterling, which is now $1.50/pound, may drop or rise over the next three months, affecting the value in dollars that the group ends up with when selling the pounds in the future. Let us suppose that the group does not want to take on this risk and headache, and that it wants to assure itself right now of a fixed number of dollars. It can use the foreign exchange market, selling its 100,000 pounds for $150,000, and investing in those dollars at interest in the United States.

Whether or not the group ends up making more money by getting out of sterling now is of limited relevance, since the group has decided that it does not want to have the value of its wealth depend on the future of the exchange rate between sterling and the dollar.