Question

Three strategies can Firm use to minimize the risks of fluctuating exchange rates. Use examples.

(broad question)

Answer 1

There are three forms of disruption in exchange rates:

Transaction risk, primarily affecting importers and exporters;

Translation risk, which may have a huge effect on U.S. asset owning firms.

Economic risk resulting from improving the local currency and making businesses less profitable than their international counterparts;

It can be risky and fairly expensive to do business abroad without protection. Currency hedging is one of the safest ways to protect profits, and stop putting your company at risk. Advantages include protection against unfavorable currency movements, reduced exchange-rate uncertainty and the freedom to focus on the primary activities of your company while protecting your profit margins, which in turn allows you to set financial forecasts when planning cash flow.

A forward contract is an agreement between two parties to buy or sell an amount at a rate and date which is set in advance. It can be open or closed, allowing businesses to hedge against unfavorable movements in currency. However, it is a firm commitment that can not be rescinded.

A currency swap is a cash flow control method very common for foreign currency inflows and outflows at various or unpredictable times. It can solve problems with matching cash flows in foreign currency, move up or extend a forward contract and avoid unproductive surpluses. Nevertheless, enterprises can not capitalize on favorable currency movements and the swap cannot be cancelled

The Vanilla (or Classic) option allows buyers to buy or sell an amount of foreign currency at a date and rate that is set in advance. An choice is a bit of protection that a buyer carries out against adverse currency fluctuations, where the choice holder must pay a fee, as in protection plans. A call option protects importers from potential monetary appreciation while the put option protects exporters from currency depreciation