Currency Hedging
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What is hedging? Hedging is a strategy used to protect risks posed by worldwide currency fluctuations. One hedges the currency risk by contracting to sell foreign currency in the future, at the current exchange rate (Fries). If fund managers think the dollar is going to be stronger when they are ready to change the foreign currency back into American dollars, then they take out a foreign futures contract (a hedge). Thus, they lock in the exchange rate beforehand, so that they will not lose profits gained from holding devalued foreign currency (Hedging, 1999). If the manager guesses correctly, he will boost the funds overall return because the profits will be worth even more when they are exchanged into American dollars.
The foreign exchange market is one of the most important financial markets. It influences the relative price of goods between countries and can shape trade. It influences the price of imports and can have an effect on a countrys price level (inflation rate). In addition, it influences the international investment and financing decisions. Exchange rates present many risks to a company and a company must be able to hedge itself (Gray, 2003).
The price of one currency expressed in terms of another currency is called an exchange rate (Gray, 2003). Foreign investors need to sell in a foreign currency to be competitive. By making the most of the exchange rate risk, it may take away some of the risk of the cross border trade from customers. This in turn may encourage a customer to buy products.
Exchange rates are the amount of one countrys currency needed to purchase one unit of another currency (Gray, 2003). Typically, vacationers wanting to exchange money will not be bothered with shifts in the exchange rates. However, for multinational companies, dealing with very large amounts of money in their transactions, the rise or fall of a currency can mean receiving a surplus or a deficit on their balance sheets, which is an example of translation risk. Translation risk is more of an accounting issue, and refers primarily to the impact of exchange rates on earnings and balance sheet items (Hedging, 1999).
Another type of exchange risk faced by multinational companies is transaction risk. If a company sells products to an overseas customer, it might be subject to transaction risk. Transaction risk refers to actual conversions of cash flows from one currency to another (Hedging, 1999). For purposes of business, transaction risk is the more relevant of the two.
Selling in foreign currency implies that some time period before a contract is agreed upon, there will be a quoted price for the goods using an exchange rate that appears appropriate (Gray, 1999). However, economic events have a habit of upsetting even the best-laid plans. Therefore, one may want to have a strategy for dealing with exchange rate risks.
The globalization of goods and services has increased rapidly during the last few years. This challenge offers a great deal of opportunities for multinational corporations, but there is a lot of risk involved. In order to decrease the risk in multinational operations, companies can be involved in the process of hedging. The major purpose of hedging is to establish a future price today. Some of the tools available to corporations that want to use hedging are futures-contracts, forwards-contracts and currency options (Kaeppliner, 1990). A bank will be able to give advice on the best means of hedging foreign currency risk, such as futures-contracts.
Futures-contracts are a standardized commitment that describes the key features of a transaction:
The quantity and quality of the commodity being exchanged
The date on which the exchange is to take place
The method of delivery
The price at which the commodity will be purchased (Hedging, 1999).
Foreign currency bank accounts and foreign currency borrowing may