I am facing difficulity to understand the decision regarding the decision overhedge/underhedge in the currency position.

Investor takes long position in Base currency and the  base currecny depreciates. what should i do?

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Given that youve lost money marked to market since youve gone long the base ccy without any hedge, you could do a lot of things:

– keep the position on by waiting for the base ccy to appreciate

– cut further losses by selling it and getting done with it

– hedge against further downside (at the same time hoping for the base ccy to go up) by entering into a ccy forward to sell the base ccy at a certain fixed rate

– buy more of the base ccy now given the lower rate if you expect it to rise

– go net short the base ccy (effectively taking a short position after closing your long position) if you expect the base ccy to fall further

– find a third ccy where the base or quoted ccy moves in a similar/opposite direction or a commodity or any other asset class and take positions accordingly.. etc,etc.

But if your question meant that youve taken a long position in the base ccy, youve to hedge a fall in the same depending on your wish. You could underhedge by going short a ccy forward on the base ccy for that pair (shorting lesser of the base ccy than calculated) and make a lesser profit on the forward if the base ccy falls and save more if it appreciates else, overhedge by doing the same but shorting more of the base ccy thereby making a greater profit if the base ccy falls and save lesser money if it appreciates.

Think of over and under hedging like bread and jam. Lesser jam on the bread, leaves more bread taste relatively. Jam spilling out on the sides leaves lesser bread taste relatively. The choice is yours if youre unable to spread jam evenly!!

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