Forward Contract

Topics: Currency, Foreign exchange market, Exchange rate Pages: 6 (1650 words) Published: March 15, 2013
To what extent does a currency forward contract need to play a formal role in multinational companies?

A globalisation has risen over the last 20 years. Because of this factor, international markets have increased rapidly, therefore a large number of companies have been particularly interested in global operatings, such as, export trade, import trade, overseas sales (Moosa, 2003). A subsequent significant trouble looming large for multinational firms is a fluctuation of exchange rate because generally international transactions denominate in foreign currency. This state makes it clear that international organizations are confronted with profit or loss from unpredictable exchange rates whereas companies, which process transactions in their country, do not (Barumwete & Rao, 2008). This essay will examine how a currency forward contact is applied to reduce exchange rate risks in volatile value of currency situations plus how favorite currency forward contracts are, compared to futures contracts. Risk can be defined as an unscheduled movement that generates unfavorable effects on value or profitability of corporations (Barumwete & Rao, 2008). In addition, an exchange rate can be described as value of a particular currency that can be converted to another currency (ibid). Therefore, Shapiro (2006) identifies a foreign exchange rate exposure as “a measure of the potential changes in a firm’s profitability, net cash flow, market value because of change in exchange rate. A tool that can eliminate or reduce unwanted section of risk can be defined as a derivative (Hillier, 2010) As a global organization, it is well established that a considerable issue, which may occur after processing international business transactions by using foreign currency, is an exchange rate risk. This is because when companies operate internationally, sometimes different currencies are utilised to process activities. The common objective of establishing a company is making profits. However, a fluctuation of exchange rate is one factor that affects profit. Eiteman et al (2007) states that a greater number of firms make an effort to evaluate, control and manage impacts of an exchange rate. In this case, a hedging instrument is applied to decrease the risks from an unexpected exchange rate fluctuation. In other words, “the main purpose of a hedge is to reduce the volatility of existing position risks caused by the exchange rate movements (Barumwete & Rao, 2008, p.8). Data from Bank of England (2012) shows the value of US Dollar against Pound Sterling had oscillated extremely between $1.3647 and $2.1105 per £1 over 5 years (Figure 1). This volatility of exchange rate can be hedged by these derivative instruments, namely, currency options, foreign exchange forward contracts, currency futures contracts and currency swaps. In 1994, Phillips (1995) shows an instrument is the most utilised. As a result, a currency forward contract is the most preferable instrument that covered 52.58% of 291 American companies, which use derivatives to hedge foreign exchange rate risk- from 415 returned surveys of 657 organization that apply at least one of those hedging. Whereas, among those 291 firms, adoption rate of swaps, options and futures accounted for 21.65%, 19.93% and 5.84% respectively (Table 1). Moreover, Belk and Glaum (1990) , Rumby and Jones (2003) and Geczy et al (1997) state that the most favorite approach utilized to protect exchange...
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