A currency options hedge is a technique used to protect against losses because of currency fluctuations. Currency traders, international banks, importers and exporters all use hedges to reduce risk.
Hedging
Hedging is essentially the practice of insuring a position. This technique is used in many markets and the currency market is no exception. People who have to exchange currencies at some time in the future use currency options hedges to protect themselves against swings in currency values.
Currency Options
An option is a derivative that allows the holder to enter an underlying market at a specific price. Therefore, currency options allow the holder to buy or sell a currency at a specific exchange rate. Currency options expire after a set period.
Practical Application
Currency option hedges are often used in international business. For example, an American importer may agree to buy some electronics from a Japanese manufacturer at a future date. The transaction will be carried out in Japanese yen. The American importer creates a hedge by purchasing currency options on the yen. Now, the importer is protected if the yen gains value against the dollar.
