The following is a gently introduction to the world of hedging.
Let suppose I loan 5000 Euros to my younger brother in Hungary in August, 2005. Since he leaves in Hungary, he would like to receive this money in Hungarian Forint. He pays me back this loan exactly one year later in Hungarian Forint.
In August, 2005, 5000 Euros are exchange to 1.225.000 HUF. Because the exchange rate was 1 EUR = 245 EUR at that time.
One year later, he pays me back the 1.225.000 HUF. In August, 2006, 1 EUR = 279 HUF. So I get 4390.7 EUR.
That is a loss of 609.3 EUR! And I cannot even back out of the loan as he is a family. So what can I do?
Large companies can ask the banks "Hedging Consultant" to help to solve the situation. In fact, it is very surprising to me that many large companies do not know that such services are available for them. But what can you do if you are not a large customer of a bank? Can you protect your money against such currency changes?
The poor-man way of hedging
I choose one of Forex broker websites. I open an account with 200 Euros on it. The leverage they provide is 1:100. I need to choose a broker that supports Hungarian Forint - one of the banks, let say.
In this example, I choose a Forex broker that does not pays or deducts interest rates from the trades as that would complicate a bit this example.
At the same time when I give the loan of 5000 to my younger brother, I also open a trade with this Forex broker.
And I "go short" on Hungarian Forint. That is: I sell Hungarian Forint, and buy EUR at the same time. It takes 50 EURs (1:100 leverage) to make this trade.
What I did? I simply entered into an opposite trade with my loan. In the loan, I was buying Hungarian Forint on my Euro. In the trade at the Forex dealer, I do the opposite, I sell Hungarian Forint, and buy Euro. Luckily, thanks to the 1:100 leverage, I only need 50 EUR for the trade.
In August, 2006 when my younger brother pays me back the loan and I get 4390.7 EUR from him. I also close this trade with the Forex broker. The Forex trade will be in a profit of exactly 609.3 EUR! Just the money I needed to get out of this.
Why is this?
So at the start, I was selling HUF and buying EUR at the Forex broker. I was selling 1.250.000 HUF for 5000 EUR.
To close this trade, I need to buy back this Hungarian Forint on the current price. In August, 2006, the price for 1.250.000 HUF is only 4390.7 EUR.
So in practice, I have bought for 4390.7 EUR Hungarian Fortint and I have sold it for 5000 EUR. So I made a profit of 609.4 EUR on this trade.
What would have happened if HUF gets stronger during this one year?
In that case, I make exactly as much loss no the Forex trade as my younger brother pays me more money.
By the way, this is why I would open the account with 200 Euros because the Forex broker automatically closes my trade if I don't have enough money on the account to cover my losses. I was thinking that 200 Euros is large enough to cover the one year.
Understanding the above calculation is not easy. But it is the basics of hedging against currency exposures.
In a professional hedging word, I could have used some other more sophisticated currency tools instead that are more suitable for this purpose but understanding these are well beyond this article.
Hedging International Loans
Many people in Hungary get loans from Swiss banks because its much more beneficial interest rates. Swiss banks interest rates are considerable lower than those of a Hungarian bank.
Unfortunately, this exposes people to a considerable currency exchange risk for a long term.
What if the Hungarian Forint falls against the Swiss Frank? It means people will need to pay much larger monthly installments. Maybe, they are not even possible to pay it.
So in a 30-year loan, understanding hedging can be quite beneficial for everyone.
Many people do not even think, it is possible to protect against such events. As the above article demonstrates, it is possible even if it might take a head-ache to follow the calculations. Note: many Forex brokerage firms offer hedging service for private customers.