International Financial Management
Table of Contents
2.1 Purpose of hedging foreign exchange risk
2.2 Alternative hedging techniques
3.1 Calculations using forward contract
3.2 Calculations using money market
3.3 Calculations using billing in US dollar
4.1 Features of fixed contract
4.2 Features of options contract
This report contains a brief understanding about the foreign exchange risk and the various techniques used for hedging against these risks which is very important for International Financial Management in the current market scenario.
The problem stated in the assignment about a US firm which is due to receive 500mn Mexican Pesos in 6 months time is a real time situation provided to us. It gives us an opportunity to think as analysts, evaluate the situation, perform calculations and suggest the firm to take the most profitable hedging approach. It also gives an opportunity to understand and explain the various hedging techniques available in the market.
Further study of the report makes us familiar with the features of fixed contracts and option contracts. Extracting information on these topics has been very informative and productive in terms of gaining knowledge.
2.1 Purpose of Hedging Foreign Exchange Risk
Hedging is a technique for risk management, performed to safeguard foreign exchange vulnerabilities against the unpredictability of exchange rates. Hedging can be performed using techniques like Currency Futures, Forward Contracts, Currency Swaps, Money Markets, Currency Options, etc. by acquiring neutralizing positions against the underlying asset. To create stability between risk opportunity loss and uncertainty is a demanding act in hedging. Hedging is a risk in itself, and could be destructive if utilized inaccurately and with the desire of doing speculation. Hedging refers to a situation; where a company or an individual can safeguard the price of their financial investment at a future date by taking an opposite position in the present date.
When 2 companies from 2 different countries do business with each other, they exchange currencies. When one company receives payments from the other company and vice versa, they have to consider the exchange rates of the countries. Foreign exchange risk refers to the risk that the exchange rates will change before the currency is paid or received. There are different types of foreign exchange exposures: Transaction, Economic and Translation exposures. Transaction exposure: measures the change in the value of financial liabilities obtained prior to the change in exchange rates but to be paid-off after the change in the rates. Economic exposure: measures the change in the present value of the company caused due to any change in the expected future operating cash flows which is caused by unpredictable changes in exchange rates. Translation exposure: measures the probable gains or losses that appear on the consolidated financial statements due to varying exchange rates.
2.2 Alternative Hedging Techniques
Hedging with Options - Currency options can be defined as an arrangement between 2 parties where the buyer of the option has the right but does not have any compulsion to buy or sell currency at a defined exchange rate, on or before a specified date, from the seller of the option. There are two types of options - Call options - buyer posses the right to buy currency at a defined exchange rate on or before a specific date. Put options - the buyer posses the right to sell currency at a defined exchange rate on or before a specific date. Seller of the option is rewarded with a premium of the option in the event a buyer utilizes the right. Thus in such a situation it is obligatory for the seller to receive the premium of the option.
Hedging with Futures - Currency futures is traded in the futures...
References: Pandey, IM. (2010) Financial Management, 10th Edition, Vikas Publications.
Fabozzi,F. (2003) Financial Management and Analysis, Second edition, Wiley.
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