Hedging Strategies

Topics: Currency, Exchange rate, Foreign exchange market Pages: 8 (2376 words) Published: December 9, 2010
A hedge is a position to minimize unwanted risk or to manage operating and transaction exposure. The goal is to compensate the loss in value of one item with the increase in value of the offsetting item. There are different reasons for hedging a position; first of all, the price increase and the fluctuation of price are volatile. Secondly, every company should have a fixed calculation basis or price basis to plan a short and long-term horizon. If not every buyer of a company does not know how to deal with the budget. Furthermore, there are a lot of different possibilities to hedge a position, but the easiest way is hedging with complete specific financial vehicles. Without hedging is business nowadays impossible and more gambling.

The first hedging strategy is called contractual risk-sharing. This method includes two parties which sign a contract for exchange rates. The contract sets boundaries for the exchange rates and reduces the risk for both parties. In this context, the construction of the contract should be fair and reasonable, but this is very seldom. Often, there are quality impacts and other problems, which conclude into disaffection for one party of the contract. So the decision-making for a construction is very important.

This type of strategy includes two parties again; a company finances their foreign operations in a local currency. The goal in this scenario is to find a similar firm which is in the same situation. If this is possible, each firm will take out a loan and both firms will swap their loans for a given period of time. The basic of the method is to reduce the foreign exchange risk.

In this case, the company uses a long-term currency option to hedge the exchange risk. This proceeding is prohibitively expensive, because long-term options are composite short-term options, so the company has to buy various options. Another disadvantage is the uncertainty about changes in competitiveness, this could change every day and is hard to hedge.

A further hedging strategy is called currency swaps. In this method, the firm switches the denomination of outstanding loans. The company looks for a partner in the foreign country in the same situation that is capable of borrowing in foreign currency with lower costs. So they will set up a swap with this company.

Also, is called as Matching Currency Cash Flows - this proceeding is much differ to the other strategies. In this scenario, no financial products or partners in foreign countries will be need anymore. The principle of this concept is easy, the company receives cash inflows in a defined currency (i.e. dollar $) and finances their operations in the same currency. It is important that the dollar inflows are perfectly matched with dollar outflows in time and volume. So the company is not dependent about fluctuation of prices anymore. But it is questionable, if a perfect matching is ever possible, because inflows and outflows perfectly in time are nearly impossible.

For example:
BMW acquire debt capital in the US dollar markets
Use US dollar cash inflows from export sales to service principial and interest payments •Be “naturally hedged”

The exporter typically has operating cash inflows in one or more foreign countries. These foreign currency cash inflows could be hedged by locking in foreign currency cash outflows through financial markets. The exporter has several possibilities to hedge. First of all, the firm could sell foreign currency with long-dated forward contracts. Secondly, they could finance a foreign project with foreign debt capital. Another proceeding could be the use of rolling hedges to repeatedly sell the foreign currency with short-term forwards or future contracts. And the last type for the exporter is to...
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