As financial markets grow increasingly sophisticated, individuals and businesses are now able to insure themselves against most conceivable risks. Specifically, as forex markets have grown more volatile in the last decade, many businesses have begun to hedge against the risk of rapid currency appreciation/depreciation. An array of financial products can be used towards this end, including options, forwards, futures, and swaps. The principal tool used in currency hedging continues to be currency futures, in which one party agrees to buy/sell a fixed amount of a given currency at a fixed exchange rate, on a fixed date in the future. While most large corporations now have entire departments devoted solely to hedging and risk management, small firms lack the resources necessary to engage in currency hedging. Anecdotal evidence suggests that small firms that import/export simply hope that relative changes in currency values balance out in the long run. This is a risky strategy, as the Times Online reports:
If the currency strengthens the price of the goods increases, making it difficult for companies to plan accurate revenue forecasts and ultimately putting stress on cashflow. Exporters selling into foreign markets face the risk of the currency weakening.
Read More: Currency game is risky for the smaller players
In just the first two weeks of 2006, the Yen has already managed to appreciate 3.5% against the USD, costing some of the most prominent macro hedge funds hundreds of millions of dollars in losses. Hedge funds, with their vast pools of investment capital and proportionately large research teams, are usually ahead of the curve in financial markets. That so many of them failed to foresee the USD’s sudden slide has come as a great surprise to many analysts. Many hedge funds have interpreted the recent fall in the value of the USD as a harbinger of further depreciation. Accordingly, they have quickly and significantly cut their long positions in the USD, a fact that is born out by official statistics. Reuters reports:
Long dollar positions measured against the yen, euro, sterling, Swiss franc, Canadian dollar and Australian dollar were cut to 1,241 futures contracts in the week to January 3 from 24,274 contracts the week before, according to the CFTC.
Read More: Hedge funds caught out by dollar slide versus yen
Chinese officials recently approved a preliminary list of banks to make the market in currency forwards. Foreign banks, including HSBC and Deutsche Bank AG, were heavily represented, although the ‘Big 5’ Chinese Banks were predictably included. The move is a large step forward for China, as currency derivatives experience a surge in popularity. Currency forwards allow traders to essentially bet on the future direction of a currency, by entering into an agreement to buy or sell currency at a fixed exchange rate on a fixed date in the future. Yuan-denominated forwards are especially popular, as traders can speculate if, when, and by how much China will revalue its currency. Dow Jones News reports:
Once foreign-exchange fowards trading on the interbank market becomes active, it could affect the yuan spot rate and offshore yuan forwards markets. But it’s still not clear how much freedom the People’s Bank of China is likely to give banks in trading fowards.
Read More: China OKs 14 Local,Foreign Bks For Interbk Forex Forwards