Question

What motivates fls to hedge foreign currency exposures? What are the limitations to hedging foreign currency exposures?

Answer 1

Hedging is used to reduce the currency risk due to fluctuation in foreign exchange rates that can be mitigated by using hedging techniques so that increase in the foreign exchange rate can be offset by gaining through hedging. Financial Institutions (FIs) have exposures in foreign currencies but these exposures are volatile in nature due to fluctuation in exchange rate of foreign currency in comparison of domestic currency. To manage their exposure to currency risks they hedge their foreign currency risk exposure, so that the hedging can reduce the volatility of possible future gains.

The limitations to hedging foreign currency exposures are that it narrows of the probability distribution of returns and reduces possible losses as well as reduces possible gains. Another limitation is that it just reduces the possibility of risk, the risk is not eliminated.