Issues to Consider Before Choosing a Hedging Strategy - Essay Example

In the recent past the expression ‘hedging’ has been increasingly popular in the international business domain. According to Shoup “a hedge is the offset of a given position by an equal and opposite position, in which the effect of the offset reduces or eliminates the effects of a value change in both.” (Shoup, 1998 p 187) This study is going to be centered on the issue of hedging and more specifically it’s going to seek to comprehensively answer the question, “Which are the issues a company needs to consider before choosing a hedging strategy?” after this question has been answered, the paper will also make a comparison of options and forwards kinds of hedging strategies. Finally, a conclusion, based on the findings of the study, will be presented. Providers of funding to Multinational Corporations (MNCs) are likely to end up in insurmountable losses if the MNCs to which they led money run in to financial predicaments. This is since international business undertakings are mostly exposed to risks of exchange rates. This is the point at which the essence of hedging is felt. (Madura& Fox, 2007 p 359) Exchange rates risk is defined as the risk to which investments are exposed due to fluctuations in the rates of exchange. Mostly, the exchange rate risks which are known are those that arise to foreign currency quoted investments. The most common investments that are exposed to exchange rate risk are purchases and sales of shares in foreign nations or even bonds. Also, those investors who have business carrying out their operations in different countries or who indulge in exporting, are exposed to this kind of a risk. For example; a person who exports is likely to experience a decline in gross margin or even a sales revenue fall due to the local currency’s appreciation. Another investor with a subsidiary company in a foreign country may also experience fluctuations in the profits due to exchange rates’ changes overnight. (Money terms.co.uk 2009) Hedging thus is essential to avoid relatively large swings in a business’ earnings, and is commonly undertaken over a short period of time. Therefore, most hedging instruments cover periods of less than one year. Usually, the rates of exchange are subject to fluctuations and thus, they cannot be forecasted with precision or accuracy. What remains in this situation is, for the specific firm considering hedging, to decide the magnitude of its exposure to the fluctuations of exchange rates. Before choosing the techniques to reduce the risk to which a firm is exposed, the firm has to fundamentally consider the degree to which it’s exposed.(Madura and Fox, 2007,P359). Mainly, there are three kinds of risk exposures. These are Translation, economic and Transaction exposures. ( cuckee.com, 2007) Translation kind of exposure is also referred to as the accounting exposure. This occurs where the balance sheet’s as well as the income statement’s items are supposed to be presented in line with the parent company’s currency terms during the consolidation process. This exposure depends upon the components of the financial statements and their conditions. Some of the items in the financial statements are exposed while others are not exposed to the risk of exchange rate. The methods used to measure the translation exposure are current /non-current, current as well as monetary/non-monetary methods. Examples of companies that may face this kind of exposure are Kellogg Company which has its parent company in the U.S.A but has many subsidiaries worldwide. The economic type of exposure is in most cases considered as the most significant of the three kinds. This is the change in a business’ value due to unexpected fluctuations in exchange rates. These unexpected risks of rates of exchange are usually unaccounted for. For example; a rise in inflation levels in U.K may have the effects of declining the outflow value from U.K and escalating the cost financing of investments in the U.K. Transaction type of exposure is the profits or losses that may arise while settling a foreign exchange business transaction. These may include; purchases or disposals of commodities, money lending and also those transactions involving acquisitions and mergers. For examples movement pattern between two currencies like the U.S $ and Euro £ may give rise to this. (Bravo, 2003, Pp 149-152) Hedging strategies may differ depending on the risk exposures explained earlier. The instruments used to hedge against these risks are usually known under an umbrella name ‘Derivatives’. Translation risk exposure, for example, is hedged non-systematically and very infrequently. This is often to make sure that the impact of any currency shocks upon net assets is avoided. This kind of risk concerns mainly long-run foreign exposure, like subsidiaries’ valuation, the equivalent debt structure as well as international investments. Due to the long-term effect, and also due to the fact that it affects the balance sheet items more than those of the income statement, this is a risk that is usually less prioritised. However, under translation risk exposure’s hedging, some items are considered separately. For example; volatility of earnings calls for a firm to use the optimisation model type to devise strategies of hedging to control the currency risk. The side effects of translation risk hedging are, however, often still evident. Hedging may lead to volatile earnings or even cash flow volatility. The decision here thus must be to or not to hedge the risk. Economic risk can be hedged using options. However, options cannot be used to hedge against the transaction kind of risk exposure. The economic risk is usually hedged against like a residual risk. It’s usually hard to quantify and it usually shows potential risks due to exchange rate changes. Transaction risk on the other hand is often hedged against strategically so as to preserve earnings and cash flows depending upon future prospects of a firm on movements of currencies. (Papaioannou, 2006, Pp 7-8) Speaking about types of derivatives, a derivative is defined as a kind of a security instrument that has its value depending upon the underlying asset’s price. Derivatives are many security types. Examples may include the already mentioned options and also futures (forwards) among others. Options involve a contract usually written by the person selling and it passes the right to buy to the purchaser. However, it doesn’t transfer the obligation as well. There are basically two types of options. These are a put option and a call option. A put option is the right bestowed to the buyer to sell. Purchasing a put kind of option from a seller, therefore, gives the purchaser a right to sell that option. On the sale of such an option, the person who initially sold the same option has thus to fulfill the contract terms. On the other hand, a call option gives the buyer of the option a right to purchase a given quantity of a given security as per the agreed amount. The price at which the security is agreed to be bought is called the ‘strike price’. The buyer in this context is supposed, however, to exercise his/her right before it expires. (European Commission& World Bank, 1999 P 113) To apply in the issue of exchange rates, the seller of a put option for a currency grants the buyer a right to dispose the currency at the price specified (this is known as the strike price) and this must be in the period of time specified. A currency put option does not oblige the buyer to sell the option, as is the case with currency call option. A put option for a currency is said to be ‘in money’ if the prevailing rate of exchange is lower than the strike price and ‘at the money’ if the opposite is the case. (Madura, 2006 P 136) A futures type of hedging contract is a legal agreement that’s binding, between two parties often to purchase or sell asset amount of a service or good, during a particular period of time in future and at a price pre-set at the initiations of the contract in question. Under hedging, futures is a contract used for protection against an occurrence of price fluctuations of the good or service being dealt in by the seller and the buyer. There are a short hedge and a long hedge. A short hedge involves the disposal of a futures /forward contract so as to protect the selling price of the good or service a given trader is setting out to sell On the other hard a long hedge concerns the purchase of a futures/forwards contract to protect the buying price of the good or service the given trader is set out to purchase. (USDA.gov, 2007) Hedging using futures or forward’s purchase in a contract of exchange involves a commitment to sell or purchase, at a particular set future date, a currency for a set amount of a different currency. This is usually at set rates of exchange in the period of the contract. Normally, these are the steps that are followed in an exchange rate futures contract. First, purchase a foreign exchange futures contract to cover transactions payable using a foreign currency’s denomination and secondly, dispose the foreign exchange futures contract to pay for purchase that are quoted in a foreign denomination of currency. By following these steps any losses or profits upon the foreign purchases or disposables occurring due to the rates of exchange fluctuations are offset by the profits or losses realised in the futures contract of exchange. (Shim and Siegel, 2007 P 459) The conclusion that can be draw from this discussion therefore is that exchange rates’ fluctuation can be of a potential catastrophe to a business and further to the lender of funds and thus, hedging has to be assured. Hedging, mostly, has instruments like those aforementioned of futures/forwards or options. Through, hedging, therefore, a business can not only be seen to reduce, but can in reality decrease the levels of risk exposure. Reference list: Carrada-Bravo, F. (2003). Managing Global Finance in the Digital Economy. Greenwood Publishing Group. Edition: illustrated: pp149-152. Cuckee.com, (2007). Exchange rate risk exposures. Retrieved February 10, 2009 http://www.cuckee.com/types-of-exchange-rate-risk-exposure-forex-and-finance/ European Commission and World Bank. (1999). European Union Accession: The Challenges for Public Liability Management in Central Europe. World Bank Publications: p 113. Madura, J. (2006). International Financial Management. Thomson South-Western. Edition: 8, illustrated: P 136. Madura, J. and Fox, R. (2007). International Financial Management. Cengage Learning EMEA. Edition: illustrated: P 359. Money terms.co.uk, (2009). Exchange Rate Risk. Retrieved February 10, 2009 http://moneyterms.co.uk/exchange-rate-risk/ Papaioannou, M. (2006). Exchange Rate Risk Measurement and Management: Issues and Approaches for Firms. International Monetary Fund: pp 7,8. Shim, J.K. and Siegel, J.G. (2007). Schaums Outline of Financial Management. McGraw-Hill Professional. Edition: 3, illustrated: P 459. Shoup, G. (1998). The International Guide to Foreign Currency Management. Lessons Professional Publishing: P 187. USDA.gov, (2007). Publications. . Retrieved February 10, 2009 http://www.rma.usda.gov/pubs/rme/fsh_7.html Read More