One Hedges The Currency Risk example essay topic

What is hedging? Hedging is a strategy used to protect risks posed by worldwide currency fluctuations. One hedges the currency risk by contracting to sell foreign currency in the future, at the current exchange rate (Fries). If fund managers think the dollar is going to be stronger when they are ready to change the foreign currency back into American dollars, then they take out a foreign futures contract (a hedge). Thus, they lock in the exchange rate beforehand, so that they will not lose profits gained from holding devalued foreign currency (Hedging, 1999). If the manager guesses correctly, he will boost the fund's overall return because the profits will be worth even more when they are exchanged into American dollars.

The foreign exchange market is one of the most important financial markets. It influences the relative price of goods between countries and can shape trade. It influences the price of imports and can have an effect on a country's price level (inflation rate). In addition, it influences the international investment and financing decisions. Exchange rates present many risks to a company and a company must be able to hedge itself (Gray, 2003). The price of one currency expressed in terms of another currency is called an exchange rate (Gray, 2003).

Foreign investors need to sell in a foreign currency to be competitive. By making the most of the exchange rate risk, it may take away some of the risk of the cross border trade from customers. This in turn may encourage a customer to buy products. Exchange rates are the amount of one country's currency needed to purchase one unit of another currency (Gray, 2003).

Typically, vacationers wanting to exchange money will not be bothered with shifts in the exchange rates. However, for multinational companies, dealing with very large amounts of money in their transactions, the rise or fall of a currency can mean receiving a surplus or a deficit on their balance sheets, which is an example of translation risk. Translation risk is more of an accounting issue, and refers primarily to the impact of exchange rates on earnings and balance sheet items (Hedging, 1999). Another type of exchange risk faced by multinational companies is transaction risk.

If a company sells products to an overseas customer, it might be subject to transaction risk. Transaction risk refers to actual conversions of cash flows from one currency to another (Hedging, 1999). For purposes of business, transaction risk is the more relevant of the two. Selling in foreign currency implies that some time period before a contract is agreed upon, there will be a quoted price for the goods using an exchange rate that appears appropriate (Gray, 1999). However, economic events have a habit of upsetting even the best-laid plans. Therefore, one may want to have a strategy for dealing with exchange rate risks.

The globalization of goods and services has increased rapidly during the last few years. This challenge offers a great deal of opportunities for multinational corporations, but there is a lot of risk involved. In order to decrease the risk in multinational operations, companies can be involved in the process of hedging. The major purpose of hedging is to establish a future price today. Some of the tools available to corporations that want to use hedging are futures-contracts, forwards-contracts and currency options (Kaeppliner, 1990). A bank will be able to give advice on the best means of hedging foreign currency risk, such as futures-contracts.

Futures-contracts are a standardized commitment that describes the key features of a transaction: . The quantity and quality of the commodity being exchanged. The date on which the exchange is to take place. The method of delivery.

The price at which the commodity will be purchased (Hedging, 1999). Foreign currency bank accounts and foreign currency borrowing may be appropriate where one may have costs in the foreign currency, and the exchange rate is related to that country's currency. Hedging with options means buying or selling at an agreed rate for an agreed upon period of time (Hedging, 1999). For example, if one expects to receive payment in foreign currency in three months time, one could buy an option to convert into American currency in three to four months. Options can be more expensive than a forward contract. However, if the currency movement is in the buyer or sellers favor, they may not need to use an option.

If awarded a contract, there will be no reason to be satisfied, if you are obligated to contract at a loss, because the exchange rate has moved. You could price a margin or an option into the bid; however, this may mean you are uncompetitive. There is a risk that a business' operations or an investment's value will be affected by changes in exchange rates. For example, if money must be concerted into a different currency to make a certain investment, changes in the value of the currency relative to the American dollar will affect the total loss or gain on the investment when the money is converted back.

This risk usually affects businesses, but it can also affect individual investors who make international investments, also called currency risk (Investor world).

Bibliography

web rate risk. html retrieved February 27, 2005 Fries, Bill.
Thornburg Articles. Currency Hedging retrieved February 24, 2005 from web Phil and Irwin, Tim.
2003).
Allocating Exchange Rate Risk in Private Infrastructure Contracts retrieved February 24, 2005 from web Currency Risk with Options and Futures retrieved February 25, 2005 from web Peter (1990).
The CPA Journal Online Foreign currency hedging transactions under Section 988 Temporary regulations Retrieved February 24, 2005 from web.