THE ADVANTAGES AND DISADVANTAGES OF ALTERNATIVE FOREIGN CURRENCY HEDGING INSTRUMENTS
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THE ADVANTAGES AND DISADVANTAGES OF ALTERNATIVE FOREIGN CURRENCY HEDGING INSTRUMENTS
Every business endeavour or venture is constantly faced with financial management problems to which the owner or manager should be able to attend to in order to take the business to success. Key financial decisions normally confronts the managers in issues and problems that concerns financial investments they usually provide answer to the problems regarding the assets on which the company of firm needs to put money and how a chosen investment should be financed.
As the nature of financial management becomes more and more complex in this information and efficient communication era of international business, finance managers face a wide array of challenges, opportunities and options to enhance the investing and financing activities of the organisation as well as to minimise the inherent risks and circumstances of the financial decisions that will be made. The challenge now for the financial mangers is to explore the options and take advantage of the opportunities while taking caution in managing the risks. “Experiences differ and common usage lack precision” (Calow, 1988) with regard to risk. Risk involves both hazards and opportunities to people who undertake the risk. People evaluate results based on their evaluation of the situation based as guided by criteria of gains and losses. Furthermore, risk involves trade-offs in which there are some groups who may experience losses in exchange to others goals to profit. The trade-off influences the perception of people about the risk. Oftentimes, the risk issue revolves not on the scientific facts about the risks but the conflict of values and the acceptability of the risk of different groups with conflicting interests.
Foreign exchange risk is commonly defined as the additional variability experienced by a multinational corporation in its worldwide consolidated earnings that results from unexpected currency fluctuations. It is generally understood that this considerable earnings variability can be eliminated partially or fully at a cost the cost of Foreign Exchange Risk (Jacques, 1981). As a consequence of the increasing economic interdependence in the world, international financial markets have become one of the most important external factors for companies. Especially for import-and export-oriented enterprises, foreign exchange, inflation and interest rates as well as their volatility are crucial for success.
Basically, in finance many contend that the world has become more dangerous, both for individuals whose wealth is exposed to seemingly larger and larger swings in global equity markets and for corporations whose cash flows seem to depend more and more on unpredictable cross-border variables. The evolution of financial products in a risk sense has closely paralleled the evolution of health and safety risks. The good old days when the only real financial instruments to understand were stocks and bonds have been replaced by the arrival of new and often more complex financial products like index amortizing swaps, exotic options, finite risk insurance products, and other fancy instruments. But just as society had to take a risk on the canning process in order to reduce the danger of botulism from home canning, financial society has had to risk financial innovation. And that financial innovation has, like canning, led to opportunities to further reduce risk (Culp 2001).
With this, the idea of risk management which is known as the process by which an individual tries to ensure that the risks to which he/she is exposed are those risks to which he/she thinks he/she is and is willing to be exposed in order to lead the life he/she wants becomes the top concern in business. However, this is not necessarily synonymous with risk reduction. As indicated, some risk is simply tolerated, whereas others may be calculatedly reduced. In still other instances, some individuals may conclude that their risk profile is not risky enough. A man who is extremely late to an important meeting and about to watch his bus pull away from the curb may not only willingly fail to look both ways at a cross walk, but he might perhaps quite rationally conclude that the risk of being late is so much higher than the risk of being hit by a car that bounding across the intersection when the light is green seems like the right judgment call (Culp 2001). Hedging is part of risk management. To hedge means to minimize a company’s exposure to unwanted risk. By hedging, a certain business or a multinational business can make sure that it can create subsidiaries in other countries so that they can protect the foreign currency cash flows. By hedging the company has an option to create a subsidiary or a branch in other places thus they can give added focus in protecting its foreign currency cash flows. The next section will be discussing the advantages and disadvantages of alternative foreign currency hedging instruments such as forward, futures and option.
As stated, a hedge is considered as a financial investment which is taken out in purpose of reducing or cancelling out financial risks in another investment. The strategy which is designed to lessen the exposure of finances to an unwanted business risk is called hedging. This strategy still permits the business to gain from an investment operation. It is noted that one of the primary goal of an industry, like for example a multinational company, is to protect the value of its foreign currency cash flows. The hedge can be able to help or assists a multinational company in its objective by making sure that the organisation is not losing cash due to the changes in line with exchange rate. One is through the use of foreign currency cash flow hedging currency hedging.
The hedge will enable the company to manage the risks that will encounter. Furthermore, foreign currency hedging can help a certain multinational company to minimise the effects of foreign exchange risks and be able to sustain the capability of the foreign currency cash flows. The way firms manage the exchange-rate risk associated with their transactions depends on the nature of, and market for, the good or service for which they are exchanging value. Accordingly, hedging strategies vary considerably between exporters and importers, between export sectors, and between firms in a given sector. While revenues may be sensitive to exchange-rate movements at the individual firm level, they are more stable in aggregate across industrial sectors, across exports and across the economy as a whole, indicating that risk is well diversified.
Basically, there are three hedging instruments that a company can use to limit their exposure to risk in any venture and these are forwards, futures and options. As stated, hedging can be used to minimise financial loss that has the potential to occur in commodities, such as oil, grains or livestock, and the theory of hedging was developed as a tool to minimise the potential loss in this line of business.
At the same time as hedging was in the beginning second-hand in the trading of commodities, such as grain, oil and livestock, the use has evolved complete enchantment and has expand suburban as a tool with the purpose that can be worn in intercontinental finance, such as in the discussion of overseas currencies. When an organization endeavours to trade further than its own currency, they take the risk of it desire come across wish be the odds to the discussion regard determination alter and the enterprise can incur a pecuniary bereavement as a conclusion of this fluctuation of switch over rates. Hedging, therefore, is an important tool with the aim of can be worn to underestimate the likely passing to can be incurred at what time a set decides to do company exterior of its own currency.
Let us consider the following situation in which a business suffer in a financial loss at the time they practice business outside of its own country or currency which can be seen by examining the exchange rate of several countries.
For example, the current £/$ rate was 1.367, which means that there were 1.367 US dollars to the British pound. If we use £1,000 as our base, £1,000 would buy $1,367. Using $1,000 as our base, $1,000 would buy £731.40.
Then let say after six months the rate £/$ becomes 2.033, which means there were 2.033 US dollars to the UK pound. Using £1,000 as our base, £1,000 would buy $2,033. Using $1,000 as our base, $1,000 would buy £491.88.
With respect to this fluctuation in exchange rates results, the British pound became stronger against the US dollar. Consequently, because the US dollar was weak against the British pound, Americans could more easily export their goods and services to the UK, but would not necessarily feel they were getting value for money by purchasing British goods and services. The weakened US dollar, therefore, could in essence cause and import/export imbalance between the two countries if it continues indefinitely.
The recent presentation indicates how exchange rates can fluctuate over a period of time, and multi-national companies must bear the brunt of these fluctuations whilst conducting business internationally. It is this risk that a business could incur a loss whilst trading internationally that they tend to use hedging techniques in an attempt to minimalise any potential losses.
Actually. forwards, which are the most widely used hedging techniques, are contracts that are made now for a payment and delivery of a foreign currency at some specified date in the future, which can be in increments of 30 days all the way up to 10 years’ time. Although the foreign currency will not be exchanged until the future date set out in the contract, the rate at which it will be exchanged will be set out when the contract is initially made. Forward markets are used by importers, exporters, borrowers, investors, and speculators. The primary use of the forward contract is to offset the exchange rate risk when the exact amount of currency involved is known in advance. Whilst many large companies use forward contracts when trading or investing, mot of the activity in the forward markets is the result of interbank transactions that are designed to minimize the exposure of individual banks (University of Leicester, 2001).
Forward contracts are drawn up between banks and their customers or between two banks. Most forward contracts are now swap agreements, which involve two forward transactions: one agreement will be to exchange specific amounts of currencies on one date and the second agreement will be to reverse the exchange on a later date, usually at an exchange rate that differs from the first date. These swaps are useful for investors and borrowers in foreign currency because they are useful in managing the exchange risk (University of Leicester, 2001).
Let us now consider a multinational business using a forward market hedge, using the exchange rates cited above, would be a UK company exporting goods to America and invoicing them for £1 million. Currently the exchange rate was 1.367, so £1 million would be valued at $1.367 million. Of course, the American company would have no way of knowing what the exchange rate would be in six months’ time, but it is expecting the US dollar to continue to weaken. With this, we may say that the American company can therefore hedge the risk of losing money on the transaction by entering into a forward contract with a bank to purchase £1 million in six months’ time at an agreed exchange rate of 2.000. Therefore, in let say in six months’ time the American company would be obliged to buy £1 million for $2 million. It just so happens that the spot rate becomes 2.033 so £1 million was valued at $2.033 million. Therefore, although the American company would have had to pay £33,000 less then they would have had to pay if they had not entered into a forward agreement at all (Lumby and Jones, 2003).
Apparently, the second hedging instrument is the future, which was first introduced in the early 1970’s. As said, futures contracts are known because they provide hedging mechanism for those organisations that would otherwise not be given access to forward contracts (University of Leicester, 2001). At the same time as futures are similar to forwards because they both involve a future exchange of currencies at agreed exchange rates, there are fundamental differences between these two hedging differences. In addition, forward contracts are flexible in terms of contract amount and maturity, however, it is lacking of standardisation. Aside form this, forwards cannot be cancelled, so the only way that a forward contract can be negated is to enter into an agreement in the opposite direction of the initial forward contract, which is known as a swap agreement. Futures contracts, on the other hand, are of a standard size and maturity date. The exchange will also reverse a futures contact as long as there are other traders willing to take on the other side of the proposed reversing transactions and it is for this reason that few futures contracts reach maturity (University of Leicester, 2001).
Despite the fact that a forward is an over the counter agreement between a bank and its customer or between two banks, a futures contract is a legally binding agreement made at a futures exchange, such as Chicago Mercantile Exchange, to buy or sell a standard quantity of one currency in exchange for another at an agreed rate of exchange and an agreed time in the future.
While a forward contract can be drawn up for any amount of money at any desired currency, a futures contract has standardized quantities with only certain currencies, such as the US dollar, UK pound, Euro, or Yen. Each futures contract is in respect of a fixed amount of currency: for example, $/£ contracts are for £25,000 each. Futures contracts are issued on a quarterly cycle of March, June, September, and December, and typically expire on the third Wednesday of the month (Lumby and Jones, 2003).
While banks generally do not ask the purchaser of the forward contract to make a deposit, the purchaser of a futures contract is required to post a daily margin, which is based on the closing settlement price of each day’s trading. The margin is a cash deposit by the buyer or seller of futures contracts and is a guarantee to fulfil the contract. Each day the exchange decides upon a settlement price for each futures contract, which is normally fixed with reference to trading that takes place 30 seconds before the close of business. If the value of the account has risen it is credited as a gain and the surplus can be withdrawn as cash; if it has fallen then it has incurred a loss. If the customer’s account records a loss and the balance of the account falls below the minimum margin requirement then the customer will be asked to increase the balance to make up the loss. Therefore, if a customer is unable to meet the losses and defaults on the agreement, the most that the exchange would suffer would be only one day’s price movement, which means the default risk of futures contracts is much lower then forwards contracts. This lower default risk means that exchanges can enter into more contracts with individuals and businesses that do not have impeccable credit ratings (University of Leicester, 2001).
For example, if an individual wishes to purchase a £25,000 contract on 12 July 2007, the exchange rate would be 2.033, so it would be valued at $50,825. The following day, on 13 July 2007, the exchange rate was 2.030 (Daily Express, 2008), so the same £25,000 futures contract would be valued at $50,750, resulting in a loss of $75. Three days later, on 17 July 2007, the exchange rate increased to 2.038 (Daily Express, 2008), so the £25,000 futures contract would be valued at $50,950, resulting in a profit of $125. Because the futures account recorded a profit, the owner of the futures account would be able to withdraw the surplus in cash.
The third hedging instrument, which is the instrument that is most suitable for multinational companies, is the options contract. Options contracts are hedging tools that companies use to reduce their risk of loss through fluctuations in exchange rates (Brealey et al, 2006).
The main difference between an option and a future or forward is the fact that the purchaser of the option contract purchases the option to buy or sell a currency or commodity and is under no obligation to buy or sell it. As a result of the fact that the purchaser of the contract is under no obligation to buy or sell the currency or commodity in question makes this hedging instrument more expensive than the forward or future. The purchaser of the option has to pay a premium for the right to buy or sell (University of Leicester, 2001).
Another differentiation of the option is the fact that whilst futures and forwards hedge the company against adverse and favourable movements in the exchange rate, options can be used to hedge the company against an adverse movement of an exchange rate, whilst at the same time allowing the company to take advantage of favourable movements in the exchange rate. It is this flexibility of the options contract that makes these instruments more expensive than the forward or future. Therefore, companies will tend to use forwards and futures if they are confident of an adverse movement in the exchange rate because those hedging instruments are cheaper than options. If the exchange rate is volatile, however, companies would be wise to use options because, even though they are more expensive, they would be able to take advantage of any positive movements in the exchange rate, should they occur (Lumby and Jones, 2003).
An example of how an option works can be illustrated by supposing a British company is due to pay $1 million in six months’ time to an American company. At the time the invoice was sent to the British company, on 12 January 2007, the exchange rate was 1.367. If in six months’ time the exchange rate the exchange rate was 1. 367 the company would choose to exercise the option and buy $1 million / 1.367 = £731,403, whereas to buy $1 million at the spot rate, or current exchange rate, would mean a cost of $1 million/1.367 = £731,403. It just so happens that after six months the spot rate was 2.033, so the company could have purchased $1 million at the exchange rate of $1 million/2.033 = £491,884. Therefore, in the worst case scenario, i.e. the spot rate went down to 1.644 and the company did not purchase an option, it would be obliged to pay £603,273 for $1 million worth of goods. If the company had purchased an option at the agreed exchange rate of 1.367 then it could pay £731,400 for those same goods if it wanted to. In the best case scenario, the UK pound strengthened against the US dollar, so at a spot rate of 2.033 $1 million of goods was valued at £491,884, and this is £22,519 less than the company would have paid if it had exercised the option, so allowing the option to lapse would have been the most profitable business decision for the company to make (Lumby and Jones, 2003).
In conclusion, hedging is merely an individual or company’s way of limiting their exposure to risk in any venture they may choose to undertake. In its simplest form, hedging can be seen as an insurance policy that is bought in anticipation of a potential financial loss at some time in the future. In the financial exchange market, there are three main hedging instruments that a company can use to limits its exposure to risk, which are forwards, futures, and options. A forward contract is perhaps the oldest foreign current hedging device, and it is primarily used for interbank transactions designed to minimise the exposure of individual banks. Futures were introduced to the financial sector in the early 1970’s and provide a hedging mechanism for some organizations that would not otherwise be given across to the forward market. They are more flexible than forwards because they are traded in an exchange, are bought and sold by brokers on behalf of the customer, are standardized for ease of use, and if a company or individual would like to liquidate them before the maturity date, they are allowed to do so. Options are perhaps the most flexible of the three hedging devices discussed in this paper. If company or a business purchases an option, they are purchasing the right to buy or sell a particular commodity or currency, and are under no obligation to exercise the contract if it would not be profitable for them to do so. It is because an option can be used to hedge the company against an adverse movement in exchange rates as well as allow it to take advantage of favourable exchange rates that this hedging device is most suitable for multi-national companies.
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Daily Express (2008). City & Business Section, The Daily Express Newspaper: London, England.
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