One of the popular misnomers about hedging is that it is a costly, time-consuming, complicated process. But it's just a misnomer!
What is financial hedge?- Natural Hedging and Financial Hedging are the two common types of hedges. Some companies will use both these methods in order to be safe from currency risk.
Natural hedging involves reducing the difference between receipts and payments in the foreign currency. Take the case of a New Zealand firm which exports to Australia and happens to forecast a return of A$10 million. Over this period, it expects to make several payments totaling A$3 million; the New Zealand firm's expected exposure to the Australian Dollar is A$7 million. In case the New Zealand firm borrows A$3 million they can also use natural hedging techniques to acquisition of materials from Australian suppliers by A$3 million as well. Now, the New Zealand firm's exposure is only A$1 million. By eliminating all transaction costs, this New Zealand firm could even open production in Australia.
This is why you need financial hedging- Banks buying and selling foreign exchange instruments and foreign exchange brokers need to be involved in Financial Hedging. Forward contracts, currency options, and currency swaps are the common types of instruments used.
Firms can set the exchange rate at which they will buy or sell a specified amount of foreign currency in the future which are known as Forward contracts. Entering a forward contract is possible if a New Zealand firm expects to receive A$1 million in excess of what they are supposed to spend in that quarter and they can get a predetermined rate for Australian Dollars every three months. Forward contracts can be used to offset the A$1 million and transaction costs can be eliminated.
If a firm doesn't have solidified plans and is bidding on a contract, they will find favorable currency options. Currency options give a company the right, but not the obligation, to buy or sell currency in the future at a specified exchange rate and date. Of course the associated upfront costs of currency options might deter some companies but this is the price to pay for favorable exchange rate movement. You will find that currency swaps are a lot like rate swaps, only more long term and help manage risk borne from exchange rate fluctuations to hedge against interest rate risk. Financial hedge can make you more profits!
Exchange rate volatility can affect a company's hedging strategy - the next post will cover why timing is key.
What is financial hedge?- Natural Hedging and Financial Hedging are the two common types of hedges. Some companies will use both these methods in order to be safe from currency risk.
Natural hedging involves reducing the difference between receipts and payments in the foreign currency. Take the case of a New Zealand firm which exports to Australia and happens to forecast a return of A$10 million. Over this period, it expects to make several payments totaling A$3 million; the New Zealand firm's expected exposure to the Australian Dollar is A$7 million. In case the New Zealand firm borrows A$3 million they can also use natural hedging techniques to acquisition of materials from Australian suppliers by A$3 million as well. Now, the New Zealand firm's exposure is only A$1 million. By eliminating all transaction costs, this New Zealand firm could even open production in Australia.
This is why you need financial hedging- Banks buying and selling foreign exchange instruments and foreign exchange brokers need to be involved in Financial Hedging. Forward contracts, currency options, and currency swaps are the common types of instruments used.
Firms can set the exchange rate at which they will buy or sell a specified amount of foreign currency in the future which are known as Forward contracts. Entering a forward contract is possible if a New Zealand firm expects to receive A$1 million in excess of what they are supposed to spend in that quarter and they can get a predetermined rate for Australian Dollars every three months. Forward contracts can be used to offset the A$1 million and transaction costs can be eliminated.
If a firm doesn't have solidified plans and is bidding on a contract, they will find favorable currency options. Currency options give a company the right, but not the obligation, to buy or sell currency in the future at a specified exchange rate and date. Of course the associated upfront costs of currency options might deter some companies but this is the price to pay for favorable exchange rate movement. You will find that currency swaps are a lot like rate swaps, only more long term and help manage risk borne from exchange rate fluctuations to hedge against interest rate risk. Financial hedge can make you more profits!
Exchange rate volatility can affect a company's hedging strategy - the next post will cover why timing is key.
About the Author:
If you are a company managing rate swaps and financial derivatives, Hedgebook is the perfect evaluation and reporting tool. It is the key tool for interest rate swap risk management processes.
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