Skip to main content

Hedging foreign exchange risk

What Does Foreign-Exchange Risk Mean?

1. The risk of an investment's value changing due to changes in currency exchange rates.
2. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as
"currency risk"
or "exchange-rate risk"



Hedging transaction risk - the internal techniques
  • Invoice in home currency
  • Leading and Lagging: It refers to the adjustment of the times of payments that are made in foreign currencies. Leading is the payment of an obligation before due date while lagging is delaying the payment of an obligation past due date. The purpose of these techniques is for the company to take advantage of expected devaluation or revaluation of the appropriate currencies. Lead and lag payments are particularly useful when forward contracts are not possible.
  • Matching: When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other
  • Decide to do nothing.
Other techniques

Forward Contracts

A forward exchange contract (or forward contract) is a binding obligation to buy or sell a certain amount of foreign currency at a pre-agreed rate of exchange, on a certain future date. To take out a forward contract you need to advise us of the amount, the two currencies involved, the expiry date and whether you would like to buy or sell the currency. It can be possible to build in some flexibility to allow the purchase or sale of the currency between two pre-defined dates rather than a single maturity date.

Money Market Hedges
  • The idea is to avoid future exchange rate uncertainty by marking the exchange at today's spot rate instead.
  • This is achieved by borrowing / depositing the foreign currency until the actual commercial transaction cash flow occur.
  • In effect a foreign currency asset is set up to match against a future liability or vice versa

Future contracts

Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

Currency swaps

A currency swap is a foreign-exchange agreement between two parties to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency.

Currency swaps have two main uses:
  • To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan).
  • To hedge against (reduce exposure to) exchange rate fluctuations

Currency option

A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased. Currency options are one of the best ways for corporations or individuals to hedge against adverse movements in exchange rates.


Sources: 
  1. Investopedia
  2. Angelfire
  3. HSBC
  4. Wikipedia
  5. Options
Further Reading

Comments

Popular posts from this blog

Learning Curve Theory

Learning Curve Theory is concerned with the idea that when a new job, process or activity commences for the first time it is likely that the workforce involved will not achieve maximum efficiency immediately. Repetition of the task is likely to make the people more confident and knowledgeable and will eventually result in a more efficient and rapid operation. Eventually the learning process will stop after continually repeating the job. As a consequence the time to complete a task will initially decline and then stabilise once efficient working is achieved. The cumulative average time per unit is assumed to decrease by a constant percentage every time that output doubles. Cumulative average time refers to the average time per unit for all units produced so far, from and including the first one made. Major areas within management accounting where learning curve theory is likely to have consequences and suggest potential limitations of this theory. Areas of consequence: A Standard

Poll : Does CIMA, UK qualification add value

Poll : Does pursuing CIMA, UK qualification add value to a member of ICWAI, India ? Vote on the poll and share your thoughts by commenting the blog. Poll: Vote here I feel that if you are a member of ICWAI and you pursue CIMA, UK qualification, you are not adding any value to your skills since you will be learning the same. Once you are qualified, you are still a Cost & Management Accountant but from UK. For an employer, I would still have same skills and training on Management Accounting. However if you pursue qualification like Company Secretary or CPA or ACCA , your skills are enhanced with the knowledge gained during training and passing of exams. After qualification, you are bound to follow the CPD programs of ICWAI and other institute. In competitive world, employer look for people with multiple skills. Which one promotes you as professional better against your name: AICWA, ACMA or AICWA, ACS or AICWA, CPA or AICWA, ACCA Amazon.co.uk Widgets Regards, Santosh

Resistence to Change - Approaches of Kotter and Schlesinger

The Six (6) Change Approaches of Kotter and Schlesinger is a model to prevent, decrease or minimize resistance to change in organizations. According to Kotter and Schlesinger (1979), there are four reasons that certain people are resisting change : Parochial self-interest (some people are concerned with the implication of the change for themselves ad how it may effect their own interests, rather than considering the effects for the success of the business) Misunderstanding (communication problems; inadequate information) Low tolerance to change (certain people are very keen on security and stability in their work) Different assessments of the situation (some employees may disagree on the reasons for the change and on the advantages and disadvantages of the change process) Kotter and Schlesinger set out the following six (6) change approaches to deal with this resistance to cha