MNCs will normally compare the cash flows that could be expected from each hedging technique before determining which technique to apply. A futures hedge involves the use of currency futures. To hedge future payables, the firm may purchase a currency futures contract for the currency that it will be required. A forward hedge differs from a futures hedge in that forward contracts are used instead of futures contract to lock in the future exchange rate at which the firm will buy or sell a currency .
An exposure to exchange rate movements need not necessarily be hedged, despite the ease of futures and forward hedging. Based on the firm’s degree of risk aversion, the hedge-versus-no-hedge decision can be made by comparing the known result of hedging to the possible results of remaining un-hedged. If the real cost of hedging is negative, then hedging is more favorable than not hedging. To compute the expected value of the real cost of hedging, first develop a probability distribution for the future spot rate, and then use it to develop a probability distribution for the real cost of hedging.
If the forward rate is an accurate predictor of the future spot rate, the real cost of hedging will be zero. If the forward rate is an unbiased predictor of the future spot rate, the real cost of hedging will be zero on average. A money market hedge involves taking one or more money market position to cover a transaction exposure. The identified results of money market hedging can be compared with the results of forward or futures hedging to determine the type of hedging that is preferable.
A currency option hedge involves the use of currency call or put options to hedge transaction exposure. A comparison of hedging techniques should focus on minimizing payables, or maximizing receivables and the cash flows associated with currency option hedging and remaining un-hedged cannot be determined with certainty. Generally hedging policies vary with the MNC management’s degree of risk aversion and exchange rate forecasts.
The hedging policy of an MNC may be to hedge most of its exposure, none of its exposure, or to selectively hedge its exposure. MNCs that are certain of having cash flows denominated in foreign currencies for several years may attempt to use long-term hedging. Transaction exposure, meaning risk that foreign exchange rate changes will adversely affect a cross-currency transaction before it is settled, can occur in either developed or developing nations. A cross-currency transaction is one that involves multiple currencies. A business contract may extend over a period of months. Foreign exchange rates can fluctuate instantaneously. Once a cross-currency contract has been agreed upon, for a specific quantity of goods and a specific amount of money, subsequent fluctuations in exchange rates can change the value of that contract. A company that has agreed to but not yet settled a cross-currency contract that has transaction exposure.
The greater the time between the agreement and the settlement of the contract, the greater the risk associated with exchange rate fluctuations. Hedging transaction exposure are: Forward Contracts – When a firm has an agreement to pay (receive) a fixed amount of foreign currency at some date in the future, in most currencies it can obtain a contract today that specifies a price at which it can buy (sell) the foreign currency at the specified date in the future. This essentially converts the uncertain future home currency value of this liability (asset) into a certain home currency value to be received on the specified date, independent of the change in the exchange rate over the remaining life of the contract. Futures Contracts – These are equivalent to forward contracts in function, although they differ in several important features. Futures contracts are exchange traded and therefore have standardized and limited contract sizes, and maturity dates.
Given that futures contracts are available in only certain sizes, maturities and currencies, it is generally not possible to get an exactly offsetting position to totally eliminate the exposure. Money Market Hedge – this method utilizes the fact from covered interest parity, that the forward price must be exactly equal to the current spot exchange rate times the ratio of the two currencies’ riskless returns. It can also be thought of as a form of financing for the foreign currency transaction. A firm that has an agreement to pay foreign currency at a specified date in the future can determine the present value of the foreign currency obligation at the foreign currency lending rate and convert the appropriate amount of home currency given the current spot exchange rate.
This converts the obligation into a home currency payable and eliminates all exchange risk. Similarly a firm that has an agreement to receive foreign currency at a specified date in the future can determine the present value of the foreign currency receipt at the foreign currency borrowing rate and borrow this amount of foreign currency and convert it into home currency at the current spot exchange rate. Since as a pure hedging need, this transaction replicates a forward, except with an additional transaction, it will usually be dominated by a forward (or futures) for such purposes; however, if the firm needs to hedge and also needs some short term debt financing, wants to pay off some previously higher rate borrowing early, or has the home currency cash sitting around, this route may be more attractive that a forward contract. Options – Foreign currency options are contracts that have an upfront fee, and give the owner the right, but not the obligation to trade domestic currency for foreign currency (or vice versa) in a specified quantity at a specified price over a specified time period.
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