The following are some of the most common types of foreign currency hedging instruments used in today’s markets as foreign exchange hedging. While 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 Contracts – a contract in a foreign currency to buy or sell at the current foreign currency rate, and requires settlement within two days.
As a forex hedging instrument, due to the short-term 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.
For retail investors, in particular, the spot contract and the risks associated with it are often the primary reason why a forex hedge should be placed. A spot contract is often part of the reason for hedging foreign currency exposure rather than the foreign currency hedging solution.
Forward contract – a contract in a foreign currency to buy or sell a foreign currency at a fixed rate for delivery at a specified future date or period.
Foreign currency forward contracts are used as a foreign currency hedge when an investor is obligated to either make or collect a payment in foreign currency at some point in the future. If the foreign currency payment date and last trade date of the foreign currency forward contract match, the investor is effectively “locked” to the payment amount at the exchange rate.
*Important: Please note that forward contracts are different from forward contracts. Foreign exchange futures contracts have standard contract sizes, time periods, and settlement procedures and are traded on regulated exchanges around the world. Foreign exchange futures contracts may have different contract sizes, time periods, and settlement procedures than forward contracts. Foreign exchange futures contracts are considered over-the-counter (OTC) since there is no central trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide.
Foreign Currency Options – 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 (the underlying) at a specified price (the strike price) on or before a specified date (the expiry date). The amount that the foreign currency option buyer pays the foreign currency option seller for the rights to the foreign currency option contract is called the option “premium”.
A foreign currency option can be used as a foreign currency hedge for an open position in the spot foreign exchange market. Foreign currency options can also be used in conjunction with other forex and option contracts to create more complex foreign currency hedging strategies. There are many different forex options strategies available to both commercial and individual investors.
Interest rate options – 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 expiry date). The amount that the buyer of an interest rate option pays the seller of an interest rate option for the rights to a foreign currency option contract is called the option ‘premium’. Interest rate options contracts are more often used by interest rate speculators, trading companies and banks rather than retail forex traders as a foreign currency hedging tool.
Foreign exchange swaps – a financial contract in a foreign currency whereby a buyer and seller exchange equal principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or variable interest payments in their respective currencies over the term of the contract. At maturity, the principal amount is actually exchanged at a predetermined exchange rate so that both parties end up in their original currencies. FX swaps are often used by commercials as a foreign currency hedging tool rather than by retail forex dealers.
Interest rate swaps – financial interest rate contracts whereby a buyer and seller exchange an interest rate exposure over the term of the contract. The most common swap contract is a fixed-for-float swap contract where the swap buyer receives a floating rate from the swap seller, and the swap seller receives a fixed rate from the swap buyer. Other types of swaps include fixed-to-fixed and float-to-float. Interest rate swaps are often used by commercials to reallocate exposure to interest rate risk.