International Banking and Financial Markets, Foreign Currency Hedge - Essay Example

An example is the U.S. equipment manufacturer can contract to supply machinery to a foreign buyer in its local currency if the dollar strengthens against the local currency before the buyer makes the payment, and the U.S. manufacturer loses. This exposes the U.S. manufacturer to foreign currency risk. As still another example, a real estate financier can offer a fixed-rate mortgage in a profitable manner. This exposes the real estate financier to interest rate risk.

To lessen these markets risks, companies enter into hedging transactions or hedges for short. Hedges are contracts that seek to insulate companies from market risks. A hedge is similar in concept to an insurance policy, where the company enters into a contract that ensures a certain payoff regardless of market forces. A hedge is possible because different parties are affected in different ways by market risks. For example, while a gold mining company is concerned with a drop in gold prices, a jewelry maker is potentially interested in a contract to sell (buy) gold at a future date for a fixed price.

This is called a forward contract, and often is transacted in a commodities market. Financial instruments such as futures, options, and swaps are commonly used as hedges. These financial instruments are called derivative financial instruments, or simply derivatives. A derivative is a financial instrument whose value is derived from the value of another asset, class of assets, or economic variables such as a stock, bond, commodity price, interest rate, or currency exchange rate. However, a derivative contracted as a hedge can expose companies to considerable risk.

This is either because it is difficult to find a derivative that entirely hedges the risk exposure or because the parties to the derivative contract fail to understand the potential risks from the instrument. Companies also use derivatives to speculate. Counterparties that bear risk in a derivative contract are called speculators.

The most common derivatives used for foreign exchange risk management and interest rate risk management are futures, swaps and options.