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Should multinational firms hedge foreign exchange rate risk? They should to better manage the foreign exchange risks. If not, what are the consequences? The gains in the foreign country would contribute less when the foreign currency depreciated against the home country’s currency. If so, how should they decide which exposures to hedge? The firm should focus on the importance of hedging exposures to the current market and the cost that should be spent on hedging. And the internal hedge policy.
a. What is hedging? Why do companies hedge?
When a currency trader enters into a trade with the intent of protecting an existing or anticipated position from an unwanted move in the foreign currency exchange rates, they can be said to have entered into a forex hedge. By utilizing a forex hedge properly, a trader that is long a foreign currency pair, can protect themselves from downside risk; while the trader that is short a foreign currency pair, can protect against upside risk.
b. What are reasons for hedging against currency fluctuations?
If the company has a large scale of international transactions, hedging against currency fluctuations would help the company to raise further capital to meet the foreign asking price.
c. What are types of exposures faced by multinational firms?
Transaction exposure, economic exposure, translation exposure, contingent exposure.
If multinational firms hedge foreign exchange rate risk, what decisions have to be made to implement a hedging policy? a.i. What should be hedged?
Depends on how the company’s risk management team views the market risk (foreign exchange, interest rate and commodities and commodities exposures) and the counterparty, corporate and operational risk.
a.iii. How should one hedge? (What instruments should be used for hedging?) Forward (0–6) and option (6–12).
The company’s high management team. Because this is a big decision that
relate direct to the company’s monetary profitability and risks, so only the high management could have the chance to manage such a large scale of money. a.v. When to deviate?
General Motors’s overall foreign exchange risk management policy was established to meet three primary objectives: (1) reduce cash flow and earnings volatility, (2) minimize the management time and costs dedicated to global FX management, and (3) align FX management in a manner consistent with how GM operates its automotive business. The first constituted a conscious decision to hedge cash flows (transaction exposures6) only and ignore balance sheet exposures (translation exposures. The second objective was a consequence of an internal study that determined that investment of resources in active FX management had not resulted in significant outperformance of passive benchmarks. As a result, policy was changed and a passive approach replaced the active one. The third reflected a belief that financial management should somehow map to the geographic operational footprint of the underlying business. Would you advise any changes?
Why is GM worried about the ARS exposure? Should GM hedge its peso exposure? What are non-financial alternatives to hedging this exposure? The manager is facing the problem that the ARS is going to depreciate again the USD because of the Argentina government is now at serious risk of defaulting on its debt, and this had no severe impact yet on the GM’s profitability is because the government has not made relative changes such as trade liberalization. So if the peso depreciates, the debts and assets are depreciated against USD, which is the main currency that GM uses. GM should get borrow more local currency so the translational risk would be decreased, then the overall risk would be decreased.
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