Too Many Derivatives from Which to Choose - Essay Example

Feb 28, 2008. Derivatives to handle foreign exchange risks Introduction The management of a book marketing company based in the United States has decided to start its branches in Southeast Asia, the Middle East and South America. As a result of branching out the firm is now exposed to foreign exchange risks. Here we consider the various derivatives the management can use to mitigate foreign exchange risks and the cost and risks associated with each derivative. DerivativesThe risk faced by an investor due to fluctuating exchange rates is called as foreign exchange risk or currency risk.

Conventional methods used to handle foreign exchange risk include forward rates, currency future and options. The latter two methods are called as derivative markets. In this case the management does not take into account hedging using forward currency contracts as the banks have increased the charges for these services manifold. Hedging using forward contracts simply transfers the risk from the firm to the bank and hence the bank charges a large amount for these services. Now the management has to decide between currency future and options.

Hedging using Futures The future currency contract is a legal contract between a buyer and a seller in which they agree to buy or sell the currency at a future date, at an exchange rate that is fixed or agreed upon today. Though the future contract looks very similar to forward contract, the futures contract brings in more liquidity it is traded in the futures market. It is similar to share market. The most important benefit of futures contract is that firm can release itself from the futures obligation by buying the contract even before the contract expires.

Other benefits include liquidity, leverage and convergence of the futures price and spot price on the day of expiration of the futures contract. Hedging using optionsA currency option is a contract between a buyer and a seller where the buyer of the option enjoys the right but not the obligation to buy or sell the currency at a specified exchange rate before a specified date. There are two types of options. They are call option and put options. Call option gives the buyer the right to buy and the put option gives the buyer the right to sell the currency.

Options minimize the risks to a great extent. This hedging option is not of significant importance to our book firm as the option is mainly beneficial for firms bidding for overseas projects. Options are highly flexible and offer a wide range of strategies. But they are more expensive when compared to forwards or futures contract. Hence the most suited derivative for the book firm is futures contract. Conclusion The best way for the management of the book firm to mitigate the foreign exchange risk is to use the hedging using futures currency contract as the forward contracts and options are highly expensive.

The ability of the management to buy back the contract even before it expires is another added advantage of the futures currency contract and also increases the liquidity of the funds. Since futures contract is a legal obligation it can be a problem to the firm. The standardized features like contract size, expiry date may sometimes interfere with hedging. However hedging is not the only option available with the firm. The book firm can also make use of netting. It is way of balancing between the foreign receivables and foreign payables.

When the two are balanced the net position of the firm is zero and the currency risk is avoided. Among the hedging techniques, hedging using futures contract seems to the best way of avoiding currency risks. Works citedAhamed Kameel Mydin Meera. “Hedging Foreign Exchange Risk with Forwards, Futures, Options and the Gold Dinar: A Comparison Note.” Lariba.com 28 Feb. 2008