Question

Some companies refrain from using financial derivatives to manage their foreign exchange exposures. They consider derivatives such as forwards, futures and options as speculative. They also believe the long-term effect is the same regardless of whether a firm hedges since hedging results in gains sometimes and losses other times.

• Do you agree with these companies? Why or why not?
• If you are faced with currency exposures in your business, will you hedge? If so, how will you hedge?

Answer 1

a)I don't agree with the decision of the above companies,Why because  Coupled with the globalisation of the business raising international capital has assumed significant proportion during recent years.The volume of finance raised from international capital market is steadily increasing over period of years,across national boundaries.So,to stabilize the cash flows and reduce the uncertainity from financial fore casts we should use derivatives to hedge.To hedge any transactions to buy certainity to make sure that unexpected exchange rate movements will have no impact on our operations. As companies said derivatives even though derivatives are speculative but by using exchange rate forecasting we can reduce the foreign exchange exposure by hedging and the other reasons for hedging is companies may not be diversified, in terms of either product .Because of small size, they may not have access to broader capital markets.It obliges companies should transfer risk to better risk bearers that are diversified.

b) If i faces currency exposures in my business ,I will hedge by using forward contract, futures, option contract, Money Market hedge.

Forward contract: An exchange rate quoted today for settlement at a future date.

Futures contract : A standardised agreement for settlement at a future date.

Options contract : options include call or put.

Call option : It is contract that give buyer the right, but not the obligation,to buy a specified no of units of commodity or a foreign currency from the seller of option at a fixed price or up to specific date.

Put Option :  It is contract that give buyer the right, but not the obligation,to sell a specified no of units of commodity or a foreign currency to the seller of option at a fixed price or up to specific date.

Money Market Hedging : Borrow foreign currency today and exchange the proceeds to local currency today.