Jack

Forex exchange rates are essential to Forex traders, regardless of other issues. They are what ultimately determines whether your deals go through or you go bust.

The most widely used Forex pair is EUR/USD, although Forex currency exchange is large enough to facilitate an ever-increasing number of exotic currency pairs, regardless of their Forex exchange rates. In fact, due to their sheer liquidity, no other market can come even close to Forex exchange markets in terms of the overall amount of money changing hands.

What are Forex exchange rates?

Forex market is more than a mere bunch of computers networked into a cohesive machine, whose job is to trade currencies and make profit on even the slightest changes in the Forex exchange rates. We are talking about central banks, hedge funds, billionaire speculators and all sorts of financial entities. Along with you, other traders looking to leave their mark in various Forex platforms.

In simple terms, try to think of Forex exchange rates as the price of one currency, except it is in another currency – say, the price of Euros in U.S. currency in. The value of a single euro in U.S. dollars would be something like 1.13172. In other words, if the price of the EUR/USD pair is 1.13172 it means that is how many dollars you would get on a single Euro. Of course, bid and ask prices would also have to be factored in. But the point is, Forex exchange rates are what determines how much money you will make, or whether you will make any at all.

Most Forex exchange rates have four places after the decimal, as this is how little their value changes. The smallest decimal is called a pip. The one notable exception is the Japanese yen which only has two places after the decimal, because the basic unit is 100 yen. Meaning the original number would be multiplied by two – hence the “lack” of two decimals.

Exchange rates can be direct, indirect or cross – which mostly depends on where you are. For instance, a direct quote tells you the value of foreign currency in your currency. Whereas an indirect quote would tell you how much foreign currency a single unit of your currency can bring you. If neither currency is domestic to you, then you have a cross currency rate.

Forex Exchange Rates Terminology

When talking about Forex terms related to Forex exchange rates, the words “floating” and “fixed” come to mind, as well as spot and forward rates.

If a Forex exchange rate is floating it means the value is determined by the market itself (mostly), whereas some currencies are fixed to a major currency such as the U.S. dollar for practical reasons. Having said this, there is no such thing as a truly floating or fixed rate, mostly because these are currencies we are talking about here. A nation’s entire economy rests on its currency and vice versa, and to simply let it float unchecked would be akin to playing Russian roulette with the barrel of the gun pointed at you entire country.

This is why the central bank always keeps an eye on the currency it issued, even if it is ‘floating’. In practice, central banks have contingency plans in case their floating currencies reach a certain level and will intervene to keep it under control. The only difference is that they are less likely to get actively involved, either because the economy behind the currency in question is so strong that Forex exchange rates can maintain themselves, or because they are too small and lack the resources to manage these affairs in a more expedient manner.

On the other hand, maintaining a fixed Forex exchange rate can be quite daunting, if your economy is failing. It would require huge financial reserves as well as lots of effort in maintaining rates the way you want them to go. It may even prove an impossible task and an impossible challenge. The best case scenario is a controlled descent that is still preferable to hyperinflation.

Also, a Forex exchange rate can be a spot or a forward rate, depending on whether the interest rate differentials have been calculated in or not. Otherwise, the spot rate is the current market price – nothing too complex about that.

The impact of Forex Exchange Rates and Risk Management

Thanks to the effects of globalization, all of the markets in the world are interconnected, for better or worse. Whatever happens, anywhere in the world could potentially affect you and your bottom line, which is why Forex rates today are such a pain to deal with. You see, the value of a currency is far more complicated to be explained by a simple formula such as economy + supply/demand = value. Forex exchange rates do not work that way.

First of all, yes, there are major players involved, with their schemes and stratagems and you are a tiny drop in the ocean of faceless investors hoping to find their way out of the Marianna Trench that is your life. And their interests will generally trump yours by an almost inconceivable margin, but that is no excuse to get bent out of shape. Central banks are looking to enforce their policies and make sure the economies of their countries keep running, whereas most major players are looking to exploit this for their own benefit.

While you can certainly try to keep up, it is highly unlikely you will manage to stay in their shadow long enough to make a difference, at least the way you wanted to. By the time you have caught on, the opportunity will be long gone. The other theory on how to beat the system is to play at the mentality of small, individual traders and their mass actions. They can still affect the market, but only to a point.

The thing that makes Forex markets so unpredictable is the sheer number of factors that need to be accounted for, which is challenging enough on its own – that is, it would have been challenging if we knew what these factors were or even how many of them there are! At this rate, traders are basically playing a guessing game, with their entire livelihoods on the stake. Even if all of the aspects of a single currency could be accounted for, you need to remember that Forex deals in currency pairs. That means the other currency in the pair brings a completely new dimension into the game.

For instance, you would think that the Forex exchange rate of, say, EUR/USD Forex pair would depend solely on the Euro and the U.S. dollar. And it would, were it not for all the other currencies at play as well. If we bring another currency to the table, say GBP, and pair it up with the Euro and the U.S. dollar respectively, then the relationships become intertwined.

If the U.S. dollar loses some value compared to the British pound, and the EUR/GBP pair remains stable, then the EUR/USD pair would be affected as well. And with tens of currencies paired up with each other, the tug of war that is going on is practically impossible to predict. Other than being a financial savant, the only way to make Forex exchange rates work in your favor is through the use of financial derivatives.

Forex Exchange Rates vs. Derivatives

The thing about derivatives is that they are a double-edged sword. On the one hand, they can force someone to enter an unfavorable deal (from their perspective) with you, or at least pay you some sort of penalty if they think it is easier and cheaper than to follow it through. On the other hand, if the Forex exchange rate moves against you, it is you who will be getting the short end of the stick and be forced to weigh in your options. Still, if used properly on Forex markets, these can help you acquire currency that you can immediately sell at a much more favorable, spot Forex exchange rate and earn some nice income in the process.

Currency swaps are the most obvious, if a bit crude, type of derivatives. Basically, the two parties exchange some currency on the spot and agree to switch back after a while. Usually there is some sort of collateral on the side. If used wisely, this strategy can ensure you can “safely” store your currency until a later date. Your loss is someone’s gain and vice versa, but that is how Forex currency exchange works, does it not?

Other than that, there are various types of currency options available, depending on the type of the deal and the circumstances. Essentially, one party sells an option to acquire some currency at a certain rate, and the other party buys said option and gets to decide whether to exercise their rights or let the option expire. Either way, the first party gets to keep the money they received for the option itself. If the seller of the option played their cards right, the fee they received will more than cover any losses a subsequent deal would incur. But if the other side is right, they can get their hands on some easy money.

Currency futures work in a similar manner, except there is a lot more commitment on the behalf of both parties. These are standardized contracts that usually expire in three months. They are a delayed deal – one that is struck now, but money does not change hands and the deal does not go down until a later date. There is usually some sort of penalty for those who back out of it, so it is usually more beneficial to either go through with it or buy it back at a price, if the things are looking to get out of hand. In reality, only a fraction of futures actually gets carried out, but the ones that do not are also an important source of income. As well as a way of “cheating” Forex exchange rates and make them work to our benefit, for a change.

Finally, forwards are quite similar to futures, except far less regulated and on an entirely different scale. These are also deals that were made in advance and are to be realized at a later date, regardless of the circumstances. Other than the way they are regulated, there are several other peculiar features. For one, currency forwards are made between major players exclusively, which means the regulation is on an entirely different level as well. Since small fry have no way of getting in on these deals, the currency forwards club is every bit as exclusive as you might think it is. In fact, the only reason it is even being mentioned here is purely from a theoretical aspect. However, these deals usually go through, or there is a separate way of settling disagreements. After all, these players are far too big for any regulatory body to take on.

Summary

Regardless of what you think about Forex exchange rates, the importance of this subject cannot be overstated, as this does not affect just the traders on the market, but entire economies as well. In a way, by engaging in Forex trade, you are finally taking matters into your own hands, rather than to allow yourself to become a pawn in the greatest game of all. Whether you decide to play things by ear or opt for derivatives, the only thing that is for certain is that you have your work cut out for you.

Here are some useful links on the subject, in case you want to know more.

• Awesome link #1
• Awesome link #2

When it comes to Forex hedging strategies and hedging strategies in general, it should be noted that there is no single, foolproof way to ensure maximum profit with minimal risk exposure. Even though that is the whole purpose of any Forex hedging strategy!

The idea of employing some form of hedging strategy is nothing new to financial markets, but it is vital for any Forex trader to learn a thing or two about Forex hedging. At the end of the day, developing a Forex hedge strategy of their own probably wouldn’t hurt either.

Where Does Forex Hedging Fit In?

Before scratching beyond the surface of hedging Forex transactions, let’s give a few basic words about hedging and what it means. The term refers to a form of risk management, rather than gardening. The aura of mystery surrounding it can seem daunting enough, but in essence it all comes down to finding a way to limit potential losses. Preferably at a tiny expense of your future income!

When employed properly, hedging strategies, Forex or otherwise, can result in anything from a deal going through with minimal losses to the deal falling through completely, but the trader still breaks even. If the Forex hedging is not done properly those losses could be huge. Still, the basic idea is simple enough to be understood even by a beginner – and its importance more than merits the mention.

Hedging is most often employed by the largest players on the market, as a form of insurance against big losses. The key thing to notice here – they are not necessarily preventing the negative outcome from happening. In fact, this is not even possible. The purpose of hedging strategies is to mitigate the negative effects of this outcome, so prevention is not the goal. After all, fire insurance will not put out any flames, nor it is supposed to. It is there to compensate for any damage done by the fire.

Same analogy fits with Forex hedging as well. You are preparing your Forex “just in case” scenario. Hedging strategies are most effective when applied to the type of situations where the market could go either way, but it will do so in a short period of time. Any trader can make an educated guess as to which way the market will go, but there is always a chance that they are wrong. By employing a Forex hedge strategy, they can at least break even so they can trade another day.

The way to perform hedging strategies is to make two investments. The first is supposed to happen and turn in the profit. The other whose sole purpose is to offset the losses made by the adverse price action – one investment hedges the other. Those who are still toying with the romantic notion that there is such a thing as a risk-free profit opportunity need to come to their senses – Forex does not work that way. The key to success is managing the risk-to-reward ratio. Even risk reduction comes with a price, and the price is not always right.

Hedging Strategies on Forex Markets

Since all hedging strategies involve some sort of derivative, it should come as no surprise that Forex hedging strategies are no exception. In this case, the most widely used derivatives are currency forwards and options. Basically, an actual Forex investment is made as a primary means of profit. A secondary investment in a currency derivative is placed simultaneously in order to cover any adverse effects from the original investment.

Since derivatives are cheaper than actual deals, the profit from the main deal should be more than enough to offset their cost as part of various hedging strategies. And since they can be lucrative as well, a well-placed derivative just might help a trader break even and escape a potential bankruptcy. The losses from one investment are covered by gains from the other and vice versa.

In Forex terms, this means going long on one currency in a pair while getting an option or a future on the other one. That way, if the original deal comes through, the spot price will net more than enough profit to offset the cost of the derivative. The other scenario is that the market moves against the original deal, but the derivative kicks in and the status quo is maintained.

Of course, there is a negative part to the whole story. The worst part about them is that they are never 100% accurate. There are too many variables to make them absolutely foolproof, and even when they do activate, the losses are almost never fully compensated in real life. Despite what the common wisdom has to say on the matter.

Why Bother With Forex Hedging?

While hedging strategies are definitely optional in terms of modern markets and most of the money is done on long-term trades anyway, the question of validity is a legitimate one. The fact that isn’t going away is simple. The spot market is still an issue when dealing with Forex transactions, so Forex options are a way of offsetting the loss. Let’s go through an example.

Imagine a trader decides to go long on a currency pair and expects to sell at a later date, but there is no guarantee that the quote will be favorable by then. There are three basic ways to hedge against an unfavorable scenario like that:

• currency futures
• currency options
• binary options

Each has a peculiar set of characteristics that could potentially make the deal or break it.

For instance, getting a currency option on the same pair could ensure there is a safe point, in case the spot market decides to throw a tantrum. If the spot price is more favorable, the option will expire worthless, but the income should easily offset the fee for the option. Otherwise, the trader will activate the option and recoup some of the losses, if not all. The problem with this strategy is getting your hands on the right option, as someone needs to be willing to share the risk. The fee may be too great in case the trader gets too greedy.

A currency future is somewhat more reliable, even though the costs of hedging strategies are potentially higher. The biggest drawback of this scenario is that the trader would have to either find the currency to honor both deals or find a way out of a binding contract. Any miscalculation could eat away all the profits and even cause more trouble than it is worth – which is why currency futures are not very suitable for hedging strategies after all.

Finally, using binary options as a counterweight in hedging strategies may seem like a perfect solution, as long as the broker is sympathetic and reliable. The fact that they offer a fixed return and severely limited risks can make them ideal for many hedging strategies, although the potential payout leaves a lot to be desired. Once again, none of these hedging strategies will mean anything unless the broker allows it – except for binary options, because of they are traded on a different market. The fact that they can be used in this regard is the only reason they are even being mentioned in this context.

What Needs to be Done?

In a way, yes! A trader is always facing risks on Forex markets. Every time they are long on a currency pair they face either downside risk or upside if they are short. In order to develop an effective Forex hedging strategy, they need to keep track of four major aspects.

First and foremost, in order to apply hedging strategies, they need to be able to assess the risks they are facing. As well as to figure out whether a risk is even worth hedging! If a trade is too costly to hedge and too risky to follow through unchecked, then the best course of action may well be to move along and wait for a better opportunity. Then again, if risk assessment is done poorly, that better opportunity may never come, as the trader will not be able to recognize it.

Next, the trader will have to learn to accept the fact that there is no such thing as a zero-risk trade, hedging strategies or not. It all comes down to what risks they are willing or able to take. This will also account for the portion of their profit they are prepared to part with in order to alleviate some of this risk. Once again, there are no right and wrong answers to this question. It’s totally up to the trader.

Third, there comes a time to choose an actual Forex hedging strategy that suits the taste and needs of the trader in question. This is arguably the trickiest part in the entire process, as there is a myriad of strategies and they all claim astounding success. It all depends on the type of situation the trader finds himself in. sometimes options are the best medium, or it may turn out the future was the way to go all along. The choice may very well be between the long and short straddle. Or a million other factors that need to be considered. But that is for individual strategies and individual derivatives.

Finally, there is the stage where the strategy is implemented and followed through. This is the culmination of all the trader’s efforts to date. The execution is simple enough, if all the preparations were done properly – otherwise, it could turn into a nightmare. The major problem is that most traders do not realize this until it is too late. After all, no exchange rate can save a trader completely from finding himself on the wrong end of a currency future contract, at least not in real life.

Summary

Risk is an ever-present part of Forex markets. Learning to curb or handle it is a must for any prospective Forex trader. There is no escaping it, so do not even try. The entire hedging thing is purely arbitrary and optional – no guarantees are made, apart from those made by the traders themselves.

Still, there are many ways for traders to protect themselves and limit their exposure. The most obvious methods are currency futures, forwards and binary options, in combination with a hedging strategy you’re choosing.

In partaking in the act of currency hedging, a trader is essentially betting against their own positions in an effort to reduce potential losses – provided they can afford to. Vanilla currency options are the most commonly used, as they convey the right to trade currencies under particular circumstances, assuming they are more favorable than those on the spot market. On the other hand, they come at a cost, and can be a bit tricky. Futures are more reliable, but binding for both parties, while binaries offer a fixed safety net and little else. The rest is really up to an individual trader’s preferences.

As long as they can calculate the risk, factor in the costs of hedging, pick and master a hedging strategy as well as implement it in real life, traders have all that they need to join the big league – except the funds, but they will surely follow. After all, if they aim to win, there is only one thing that they absolutely must not do: they absolutely must not lose.