• Effective currency hedging manages risks and improves profits.dollar bill image by jimcox40 from Fotolia.com
  
  Foreign exchange describes the process of trading international banknotes to make and receive payments. Currency risks are adverse exchange rate fluctuations that cause your sales and buying power to deteriorate. For example, exporters may lose sales when domestic exchange rates increase. At that point, exported wares become more expensive to overseas buyers. Alternatively, consumers lose purchasing power as domestic exchange rates fall. Diversification, derivatives and swaps are hedging techniques that manage these currency risks.
  
  

Diversification

• Diversified savers purchase non-correlated investments, so that they may profit across multiple economic scenarios. Correlation relates to the tendency for two separate assets to move together. For example, the US and Russian economies may have little correlation to each other, due to the fact that America is an energy importer, while resource-rich Russia exports oil and natural gas. Sophisticated investors may diversify by opening up businesses in both the United States and Russia to hedge against currency risks. Elevated energy prices may cause the US economy and value of the dollar to fall, while Russia and its ruble experience commercial strength.
  
  Smaller investors, however, lack the financial resources to establish overseas businesses. These investors may purchase shares of stock in multinational corporations, such as Coca-Cola, or buy into global mutual funds. These diverse, international investments are effective currency hedging techniques.
  
  

Currency Derivatives

• Currency derivatives manage financial risks by locking in exchange rates throughout particular time frames. These derivatives include options, futures and forwards. Options and futures contracts are bought and sold on organized financial exchanges, such as the Chicago Mercantile Exchange. In exchange for your premium expense, options grant you the right to exercise, or accept, foreign exchange at predetermined rates. Futures, however, enforce that foreign exchange is delivered and accepted at the agreed upon rates specified by the contract.
  
  Forwards are customized agreements between two parties to set exchange rates and trade currencies at later dates. Because of their customization, forwards do not trade on financial exchanges, and lack the liquidity associated with options and futures. Liquidity describes your ability to convert any asset into cash.
  
  

Currency Swaps

• Currency swaps trade payments in different currencies between two parties. Currency swaps feature netting, instead of transferring infinite payments between both partners. With netting, one total payment is made to the winning party at the expiration of the contract. Traders often execute currency swaps alongside interest rate swaps, to hedge interest rate risks between nations. Interest rate swaps exchange payments between two parties at fixed and floating rates. The floating rate often tracks the fluctuating London Interbank Offering Rate (LIBOR), plus an additional premium amount.