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Hedging Currency risk

For instance, labour costs are such that much of the simple commoditized manufacturing in the global economy nowadays goes on in China and South-East Asia (Philippines, Vietnam, Indonesia, etc.). The cost advantage of moving manufacturing to outsource providers outweighs the uncertainties of doing business in foreign countries; so many businesses are moving manufacturing operations abroad. But the reimbursements of doing this have to be weighted also against currency risk.

Currency hedging (also known as Foreign Exchange Risk hedging) is used both by financial investors to parse out the risks as they come across when investing abroad, as well as by non-financial actors in the global economy for whom multi-currency activities are a necessary sin rather than a desired state of exposure.

If the price of manufacturing goods in other country is fixed in a currency, other than the one that the finished goods will be sold for, there is the risk that bring about changes in the values of each currency will reduce profit or produce a loss. Currency hedging is similar to insurance that limits the impact of foreign exchange risk.

Currency hedging is not all the time available, but is voluntarily found at least in the major currencies of the world economy, the growing list of which be eligible as major liquid markets beginning with the "Major Eight" (USD, GBP, EUR, JPY, CHF, HKD, AUD, CAD), which are also be called as the "Benchmark Currencies", and expands to include numerous others by virtue of liquidity.

Currency hedging, like many other forms of financial hedging, can be done in two primary ways: the first one to be with standardized contracts and the second one is with customized contracts (also known as over-the-counter or OTC).

The financial investor may be a hedge fund that decides to invest in a company in, for instance, Brazil, but does not want to essentially invest in the Brazilian currency. The hedge fund can take apart out of the credit risk (i.e. the risk of the company defaulting), from the currency risk of the Brazilian Real by "hedging" out the currency risk. In result, this meat to say that, the investment is effectively a USD investment, in Brazil. Hedging allows the investor to transfer the currency risk to some other persons, who wants to take up a position in the currency. The hedge fund has to pay this other investor to take on the currency exposure, parallel to insuring against other types of events.

As with other kinds of financial products, hedging might allow economic activity to take place, that would or else not have been possible (as a loan, for instance, may allow an individual to purchase a home that would be "too expensive" if the individual had to pay cash). The increased investment is assumed in this way to elevate economic efficiency.

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