Discuss briefly four techniques a company might use to hedge against the foreign exchange risk involved in foreign trade.

Advanced Financial Management Block Revision Mock Exams

The following techniques are available for hedging against the foreign exchange risk involved in foreign trade (note that only four were required):

(i) Forward market
This involves a contract which is tailor-made i.e, is taken out for the exact amount of currency required. The future rate of exchange is fixed at the time the contract is entered into with the bank. The cost is determined by the forward rate quoted by the bank. The contract must be fulfilled on the due date (or within the due dates for an option forward contract). Therefore if, for example, a customer is late in paying, the firm will have to buy currency in order to meet the commitment under the forward contract.

(ii) Financial futures market
This offers the opportunity to buy/sell currency in standard amounts of a limited number of currencies at a specified time and rate. It is therefore cheaper than using a forward contract but cannot usually obtain the exact amount of currency needed and requires an initial deposit.

(iii) Lead/lad payment
In the case of paying for goods in a foreign currency, it is possible to pay for the goods in advance and thereby fix the exchange rate at the spot rate.

The cost is the time value of money between the normal due date and the earlier payment date.

(iv) Money market
Here the currency is exchanged at the time of the initial transaction at the spot rate and the currency is then lent/borrowed on the money market so as to accrue to the appropriate amount to settle the transaction on the due date. The cost will be determined by the interest rate differential between the two countries.

(v) Foreign currency options
Here the firm buys the possibility of buying („call‟) or selling („put‟) currency at an agreed rate, usually at any time within a specified period. It is possible to obtain a choice of exercise prices and maturity dates; the price of the option will vary according to the exercise price and maturity date chosen.

Because options give the holder the opportunity to „walk away‟ from the contract if it suits him, options are a more expensive means of covering foreign exchange risk.

(vi) Invoice in the domestic currency

For exports it is possible to invoice in the domestic currency. This is easier for the exporter but it passes the inconvenience and risk of foreign exchange on to the customer so it may result in lower sales.

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