Foreign Currency Risk Hedging
ACC540 Advanced Topics in Financial Accounting
California Baptist University
Stephen Christie, Professor
June 21, 2013
Organizations all over the world that are involved in global transactions have experienced the risk of foreign currencies exchange rates changing over a period of time. Organizations that are aware of this risk usually participate in foreign currency hedging in order to mitigate the risk of a foreign currencies value declining before their future transaction takes place. Fair value hedges, cash flow hedges, and net investment hedges are three of the main types of foreign currency hedges that organizations use to solve their foreign currency risk issues. Organizations have also found that using options as hedging tools for foreign currency risk exposure has proven to be effective in hedging the currency risk and creating the possibility of profit too. Overall, foreign currency hedging can be complex but an extremely useful tool.
Global businesses are involved in foreign transactions on a daily basis. Many of these businesses have to deal with foreign currencies in their transactions with businesses in other countries on a regular basis. When dealing with future transactions in foreign currencies, businesses run the risk of fluctuating foreign currency exchange rates, which can negatively affect the value of the transactions. Because of this, organizations use foreign currency hedges as financial instruments in order to eliminate the risk of losing money due to fluctuations in a foreign currency’s value. Foreign currency hedging is very complex and has many specific accounting requirements that businesses are required to follow including recognition, measurement, and disclosure. Another form of foreign currency hedging is an option contract, which is becoming more popular among business to reduce foreign currency risk. Walmart is a global company that takes part in foreign currency hedges and effectively disclose their hedges in their annual financial statements. Foreign currency hedging is a great tool that has been used by many businesses to save them money and reduce risks. What is Foreign Currency Risk Hedging?
Foreign currency risk hedging refers to the process of hedging the risk that is associated with future payments or distributions in a foreign currency. Organizations involved in global transactions that occur in the future often run into the issue of volatility in foreign currencies changing value. Because the organizations experience the risk of changing currency exchange rates, they use foreign currency hedging strategies in order to mitigate that risk. Although an organization has the possibility of making a profit through the currency exchange value increasing, most investors and lenders would rather forego this profit if they could avoid the risk of currency exchange loss (Kelley, 2001). Avoiding the risk of currency exchange loss is what makes foreign currency hedging such an appealing option to businesses. Foreign currency hedging is useful because currency exchange rates are constantly changing, and there is no way for organizations to be able to know for a fact the value of a currency in the future. For example, consider a scenario where a company in the U.S. got involved in a future transaction to pay a company in Japan 1 million yen for their product on September 14th. The U.S.-based company would want to hedge against an adverse change in the value of the yen in order to avoid the risk of a loss of by the date of payment. This is a common scenario that global companies face often.
There are an incredible amount of hedges that are used by businesses. There are three main types of hedges used for foreign currency risk: 1. Fair value hedges
2. Cash flow hedges
3. Net investment hedges
These three types of hedging are used most often by...
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