Foreign exchange hedging: risk management and trading strategy analysis

In finance, hedging is a strategy designed to reduce the risk of another investment. It effectively controls business risk through specific trading arrangements while still retaining the possibility of generating gains. A typical hedging operation involves two transactions with high market correlation, opposite directions, and similar sizes simultaneously, so as to achieve mutual cancellation between profits and losses. Market correlation means that the market supply and demand bases that affect the prices of two assets are basically the same. When the supply and demand relationship changes, it will affect both assets at the same time, and the price movement trend is roughly the same. The opposite direction ensures that no matter which direction the market price fluctuates, the two trades are always profitable and lossmaking. To achieve the effect of breaking even, the position size of the two trades needs to be adjusted according to the amplitude of their respective price fluctuations to achieve a roughly balanced state.

This strategy is widely used in foreign exchange trading, and the core purpose is to avoid the latent risk of one-way trading. One-way trading usually refers to buying (going long) if you are simply optimistic about a currency, or selling (going short) if you are bearish on a currency. If the market is accurate, this trading method can be profitable; but if the judgment is wrong, the losses will be more significant than if you use a hedging strategy.

Specific toforeign exchange marketA hedging operation is usually to buy one currency (to establish a long position) and sell another currency (to establish a short position) at the same time. In theory, a complete hedging combination is only formed when the amount bought in one currency is equal to the amount sold in the other currency. If the position sizes of the two sides are not consistent, the effect of risk hedging cannot be fully realized.

The reason why this pattern is widely adopted is that most foreign exchange markets around the world are denominated and referenced in the US dollar. The rise and fall of other currencies are usually relative to the US dollar. A stronger dollar often means that other currencies are weaker; conversely, when other currencies are stronger, the US dollar is relatively weaker. The fluctuation of the US dollar affects the movement of almost all foreign currency exchange rates. Therefore, when traders are bullish on one currency but want to control risk, they usually sell the other currency they are bearish about in tandem. By buying a combination of strong currencies and selling weak currencies, if the judgment is correct, the dollar will weaken, and the purchased strong currency will appreciate; even if the judgment is biased and the dollar strengthens, the purchased currency may decline only a limited amount, while the sold weak currency may decline even more, eventually forming a situation of smaller losses and greater profits, and overall profits may still be achieved.