How to hedge the currency risk
In order to find a suitable hedging instrument, it is always important to look at first, for a correlation between stocks and indices. There are two things influencing the Yuan and thus China: copper and the China-related ETF FXI.
Hedging only matters if you want to reduce the risk when buying or selling Yuan. This can be achieved in most cases by reducing your positions’ size. However, if you can’t do that then you have to resort to other tools. For example, if you had a futures contract on CNH which was a little too big for your account, then we would trade another instrument with a similar development to reduce the risk. That could be an instrument with a high positive or an extremely negative correlation. If we assume that the Yuan is similar to the Chinese economy then we would short the FXI or copper to reduce the risk in CNH futures.
This depends entirely on CNH’s nominal value. The instrument we use to hedge should be slightly smaller in terms of nominal value. Otherwise, the hedge makes no sense because it completely consumes potential profits in the CNH. If you want to do it exactly, you would have to take the implied volatility adjusted nominal value, but it’s a bit complicated.
But what to do if you are an Importer or Exporter of goods?
In that case, you certainly do not want to gamble, just keep the currency risk as low as possible.
Hedging from the perspective of an importer of goods;
If you are in the business of importing goods, you run the risk of losing money thanks to a expensive CNY of the exchange rate rising and as you will have to pay more for foreign products. You can hedge this risk by making forwards at the bank. Or you can secure the current foreign currency exchange rate by speculating on falling prices. In the event of your own currency weakening, you will be buying your imported goods at a higher price but at the same time you will be earning money with the speculation on falling prices. From an entrepreneur's point of view, the speculation in trading is not directly related to business purposes. This fact is not part of this course.
Let’s see what is Hedging is from the perspective of an exporter.
There is the case that your own currency will become stronger than CNH and as result your own products will be more expensive. This will have as a result:
either the drop of the demand for your goods
or the decline of your currency’s value
Which of these two might happen to you depends on which currency you will be using for your transactions. In most cases, the transactions will be settled in a foreign currency (such as USD) in order to accommodate the buyers demand for you to take over the currency risk. You can hedge this risk by making forwards at the bank. Otherwise you can secure the current foreign currency exchange rate by speculating on rising prices. In the event of the currency you hold getting stronger you will be getting less, at the same time you will be making money with the speculation on rising prices. From a business perspective, the speculative business is a stream of revenue not directly related to business purposes.
An exporter runs a risk of their own currency getting stronger. In that case they will get a smaller amount of CNH when they convert the amount of USD they received for the goods they have sold.