Global financing and exchange rate topics: Corrency hedging - Essay Example

This paper will discuss how currency hedging is practiced in global financial operations. It will also explain the significance of currency hedging in managing risks. Currency Hedging To define, “Hedging means securing oneself against loss from various risks that arises in international financial markets”(Machiraju, 2007), p.94). Currency hedging is a technique related to the hedging concept and is employed for the elimination of risks associated with foreign currency transactions. For instance, consider a US based manufacturing company enters into a contract with a German business partner at $1 million.

The contract amount is expressed in Euros and 1 euro equals 1 dollar on the date of the contract. Two years later, the value of the euro increases with respect to the dollar and hence it reaches a level of 1 euro equals 2 dollars. This situation causes the manufacturing firm to suffer a foreign currency loss of $500,000. This loss can be avoided if the manufacturing firm practices any of the currency hedging techniques. . Currency hedging instruments/strategies in global financing operations There are numerous currency hedging methods that can protect a firm’s future cash flows from exchange rate fluctuations.

The firm can adopt most appropriate technique after considering a number of factors such as firm’s strategies regarding hedge, present market situations, and possibility of future exchange rate fluctuations. According to Collier and Agyei-Ampomah (2007), currency hedging methods can be classified into two; internal hedging techniques and external hedging techniques. They are described below. 1. Internal hedging techniques Under this method, the firm uses the sources or techniques available within the company in order to eliminate risks associated with exchange rate.

Since these techniques are not operated through the ‘foreign exchange markets’, the ‘associated costs’ can be avoided. Some of the internal hedging techniques are described below. Invoicing the home currency- Here, the firm transfers the exchange rate risk to customers by invoicing in its own currency. Bilateral and multilateral netting- In case of bilateral netting; ‘pairs of companies in the same group net off their own positions regarding payables and receivables’ sometimes even without the help of a ‘central treasury department’.

In contrast, a central treasury department is necessary to perform multilateral netting where ‘several subsidiaries are involved. Restructuring-The firm can manage exchange rate risk also by restructuring its business strategies such as increasing or reducing sales in foreign markets, dependency on foreign suppliers, and level of debt denominated in foreign currencies. 2. External hedging techniques Under external hedging techniques,