In the first instance currency hedging practices have their relative individual significance vis-à-vis non-currency investment opportunities and net returns on such investment vehicles (Zarin, & Zimmerman, 2006). For example investors bank their hopes on relative net returns such as Net Dividend Yield (NDY) generated by stock related investments. Thus potential investors look at how the growth trajectory of Net Asset Value (NAV) would increase in keeping with net returns in relatively less risky spheres of investment.
Secondly the risk factor associated with currency market related investments is proportionately higher when foreign exchange related investments take a plunge due to uncertain government policies. For example if the government concerned allows its own currency to depreciate externally in order to correct a deficit in the trade balance of the balance of payment, investors would be caught on the wrong foot if they happen to bank their hopes constantly on the continuity of government policy (Maskey, 1995).
Thirdly the government may adopt anti-inflationary measures such as higher corporate taxes and expenditure taxes. The net result would be less investment and less borrowing. Currency markets become dormant during such periods of negative policy initiative.
Foreign exchange rates and interest rates are positively related because when interest rates fall the exchange rates also fall because potential foreign investors do not buy the domestic currency concerned for investment when the domestic interest rates fall and as a result the demand for the domestic currency abroad falls thus leading to an unfavorable exchange rate (Larsen, & Resnick, 2000).
Hedge funds, mutual funds, pension funds, commercial banks and other money market players have a tendency to hedge risk by minimizing the degree of exposure to adverse consequences arising from