The yellow metal was once used to trade or buy goods that have been replaced by individual currencies of the economies. However, this yellow metal, gold hasn’t lost its charm. It is still one of the primary factors used to derive the value of the currency in an economy. In India, the currency in circulation is decided as per the amount of gold reserved in the central bank i.e. RBI. So, gold and currency have a strong relationship that is going on to date. So, can you use this yellow metal to hedge the risk involved in currency trading? Let’s find out whether you can do so or not and if yes, then how.
What is currency hedging?
Currency hedging refers to protecting your currencies against uncertain events in the future and their effect on the currency. It reduces the adverse effect of fluctuations in the currencies on investment performances. To hedge currency, the investors will invest in another asset which is gold here to offset any losses in currency trading.
In simple words, it is a process where you buy two different assets which are not correlated or negatively correlated. Thus, when the currency becomes volatile and the value of the currency drops, the gold prices spike up, offsetting the loss.
What is the relationship between gold and currency?
Firstly, the RBI or the central banks of any nation can print or circulate only that much money or fiat currencies in the economy against which they have gold reserves. For instance, if Rs. 10000 has been printed/minted and circulated in the nation, then gold worth Rs. 10000 has to be kept in reserve in RBI. This has been done to keep inflation in check and to allow a limited amount of money in the nation to get circulated. Also, the volatility of the currencies decreases when their value is based on an underlying asset.
Another factor that makes gold a great hedging instrument for currencies is that gold helps in hedging against inflation. When inflation rises, the value of the currency drops. However, in an economy that is in turmoil, most investors look for a haven and thus dump their monies into gold. This increases the value of the gold while on other hand, your currencies are dipping.
How to hedge currency fluctuation with gold?
Gold prices may seem volatile in the short term but in the long term, gold has been one such investment option whose price is way more stable than most the other assets. This you can use as the hedging technique as currency is highly volatile, and thus, keeping gold to protect you against currency fluctuation can help you minimize your losses and optimize your returns.
Gold prices have gone up around 511.14% in the last twenty years while on the other hand currency has devalued from Rs. 48 per USD to Rs. 76 per USD at present i.e. a devaluation of around 58%, during the same period under consideration.( approx. figures).
You can use Gold’s futures contracts or options to hedge against the risk of currency fluctuation as well. Suppose you anticipate that the price of INR will get devalued and become Rs. 80 in a month and you have to pay 10000 USD after a month to one of your overseas employees. Now, to hedge the risk of currency, you can buy gold options with 1-month expiry. If the currency gets devalued, the gold will become pricier, this way, you can offset the risk of currency.
Thus, if you are concerned about protecting your currencies, you can use gold as it has always been a great investment asset for hedging against inflation, currency risk, and others assets too. The professionals at Tata Capital Wealth can also assist you in your decision.