Instruments Used for Hedging Exchange Rate Risks in the Forex Market, Based on the Practices of Hsbc Brazil

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Instruments used for hedging exchange rate risks in the forex market, based on the practices of HSBC Brazil

Final Paper
International Financial Management

Since Multinational Corporation’s performance is affected by exchange rate fluctuations the assessment of their vulnerability relating to unexpected developments in the foreign exchange market is one of the biggest challenges for risk management. Due to the prevailing volatility of financial markets, finding mechanisms to hedge companies against exchange rate risks when trying to achieve excess return becomes increasingly crucial. The basic idea of hedging strategies is to compensate potential losses that may be incurred by an investment by assuming a position in a contrary or opposing market or investment. The value of the loss of one position is offset by the appreciation of the opposite position (= variation negatively correlated single positions). The decision process of the financial manager to choose which strategy suits the best to carry out hedging involves developing a financial plan for the company. However, the knowledge about financial products offered by the banking sector and the assessment of the extent of security required, according to the given expectations are just as important for rational decision making. Given these facts, contemporary financial institutions are constantly developing new financial instruments to fulfill the needs of firms concerning planning and security. Mitigating financial risks allows companies to focus on the management of organization's operational risk and core business. Since foreign trade relations between Brazil and China are constantly growing[1], the purpose of this paper is to introduce some of the main instruments used to hedge exchange rate fluctuation risks based on existing practices of HSBC Brazil. With their global headquarters in London, HSBC is the second largest global banking and financial services institution. Its network consist of 7,500 offices in 87 countries and 295,995 employees offering its services throughout the world to around 95 Mio. customers.[2] Besides being a leader in Europe, the bank is continuously growing in the Asia-Pacific region, the Americas, the Middle East and Africa. “With listings on the London, Hong Kong, New York, Paris and Bermuda stock exchanges, shares in HSBC Holdings plc are held by over 221,000 shareholders.” [3] 2011 it has been awarded by Euromoney for being the best “Global Risk Management House”.[4] Especially in the last 30 years several complex hedging instruments have been developed. Nevertheless, derivatives are currently the main instruments used in the financial market. According to Rubinstein[5] a derivative instrument “is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties”. Lozardo[6] defines a derivative as a financial security whose price is derived from the market price of another real or financial asset. The underlying asset of derivatives includes everything from agricultural commodities to stock prices, interest rates, exchange rates, among others. In the derivatives market, rights and obligations for future dates are traded which have none or negligible financial impact at the time the transaction is realized. Derivatives enable the exchange of financial results achieved due to index value alterations or price forecasts, in a certain period of time on a desired amount of money. The derivatives market encompasses a set of specific market segments; each one has its own logic as well as its concepts and rules, operating characteristics, pricing mechanism and negotiation methods. According to Lozardo, these segments are divided into futures market, forwards market, swaps market and options market. The further discussion of each of the segments is beyond the scope of this assignment and can be found in other...
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