According to Wikipedia-A foreign exchange hedge (FOREX hedge) is typically used by companies to eliminate or hedge foreign exchange risk resulting from transactions in foreign currencies. In other words, if a company in based in one country most of its expenses are denominated in the currency of that country. So if a company is based in the U.S. most of its expenses are in dollars. But if it sells a significant portion of its products in another country like Mexico then a portion of its income will be in Pesos. If the Peso depreciates against the Dollar the value of their income could cause them to lose significantly even though they thought they were selling at a profit. This creates the need for a currency hedge.
Two common hedges are forwards and options. A Forward contract will lock in an exchange rate at which the transaction will occur in the future. An option sets a rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option.
Forex Inflation Hedge
How can investors use Forex to hedge against inflation? Inflation leads to a reduction of the purchasing power of the residents of the affected country. For an investment to be considered a hedge against inflation, it must be able to provide protection against the decreased value of a currency. How does this happen? This occurs by the investor putting money in an asset so as to maintain or increase its value over a specified period of time. Since inflation is just the value of a currency depreciating against commodities at the same time it may be depreciating against other currencies as well. So, just as we saw that companies used forex to hedge against currency depreciation vs. other currencies you can use Forex to remove yourself from the risk of your currency depreciating due to inflation.
One way to do this is by taking a higher position in assets which lose value less rapidly than the home currency value.
Poor Inflation Hedges
Money market instruments have never served as a good hedge against inflation. Their rates of return and dollar values are fixed, so there is no room for appreciation should the value of the dollar decline. For instance, if your bank pays a 5% interest, but inflation figures stand at 6%, you are not protected against inflation and your purchasing power is actually reduced. As at the end of the year the interest you earned did not even cover the loss of purchasing power. To make matters worse you actually owe taxes on the 5% “gain”.
This opens the window for the use of Forex to hedge against inflation.
Why is it good to use Forex to Hedge against Inflation?
- It is a market where money can be made in both directions. A trader can make money by being long or being short on a currency, subject to the market moving according to his expectations. Therefore if you wanted to hedge against the value of the dollar falling you could simply short it or go long other currencies that may have less inflation.
- The rate of return in Forex is not fixed, and situations that lead to collapse of the equities markets actually provide opportunities for making money. For instance, traders could have made money in May 2012 from taking short positions on the currency pairs where the US Dollar is the counter currency (such as the EURUSD, GBPUSD and AUDUSD) or by being short on commodities.
- A well structured trading plan based on the principle of compounding can deliver returns far in excess of the prevalent inflation rate.
Forex trading carries more risk than money market instruments, but if the trader finds himself in a situation where banks are paying low interest rates, then there is no point staying with money market instruments.
A table of compounded returns shows that a $1,000 investment compounded by 15% every month will turn into $5,350 by the end of the 1st year, $28,625 by the second year and $819,400 by the fourth year.
Is this achievable? It truly is, when you consider that 15% of $1,000 is only $150. That is an aspiration of just $7.50 every trading day for the first month. It is possible to use a micro lot trade size, which cuts risk to the barest minimum, and deliver the kind of returns we have shown. Forex as an inflation hedge is a reality.
The reason why many traders fail to see this as an achievable goal is because traders assume too much risk and do not use a long-term view in trading forex. The reason why the smart money players seem to do better in the markets is not because they use complicated trading strategies. They minimize risk in order to maximize returns over time. So in order to use forex as an inflation hedge effectively, traders are urged to trade like the smart money players, by keeping risk low and compounding returns over time.
- So Long, US Dollar As World’s Reserve Currency
- Why (and How) China is Boosting the Price of Gold
- Its Weight in Gold: The Real Prices of Things
About the Author:
This article was written by Adam Green, who has more then 10 years experience trading in the Forex, binary options and commodities markets. He also runs a number of his own financial trading websites with trading strategies and analysis.