Pros and Cons of Hedging Foreign Exchange

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Analyse the pros and cons of hedging foreign exchange transaction exposure, and examine the alternatives available to a firm to manage a large and significant transaction exposure. (600 worlds)

Many firms attempt to manage their currency (foreign exchange) exposures through hedging. Hedging is the taking of a position, acquiring either a cash flow, an asset, or a contract (e.g., a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position While hedging can protect the owner of an asset from a loss, it also eliminates any gains from an increase in the value of that asset.

A major motive for firms to hedge is to increase the present value of firms. The value of a firm is the present value of all expected future cash flows in the future. For expected cash flows with higher risk, a higher discount rate should be applied to calculating the present value and thus a lower present value for these cash flows is generated A firm that hedges these foreign exchange exposures reduces the risk in the value of future expected cash flows (see Exhibit 11.2) (Eiteman, D. K, Stonehill, A. I, Moffett, M. H 2009). Therefore a lower discount rate is used to calculate the present value of likely future cash flows, which increases the present value of the firm.

However opponents of currency hedging argue the following, saying that a reduction in the variability of future cash flows is not sufficient enough. Firstly, shareholders are more capable of spreading out currency risk according to their individual preferences and risk tolerance instead of the management of the firm. (Eiteman, D. K, Stonehill, A. I, Moffett, M. H 2009). Secondly, currency risk management can reduce the variance reducing the expected cash flow due to hedging costs meaning that the real benefit of hedge depends on the trade-off between these two effects. Thirdly, shareholders often feel that hedging activities are sometimes conducted to benefit the...
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