Question

Can you briefly explain in some paragraphs on how public companies deal with exchange rate risk and how actually rate changes affect firms?

Answer 1

Exchange rate affects firms in many ways . It can affect firm directly or indirectly . If a firm has to pay 1,00,000 euro after one month . Earlier the rate was 1$= 50 euro and In future it can be 1$= 40 euro . When rate was 1$ = 50 euro ,you should have 2,000$ to pay 1,00,000 euro . But when 1$ will be of 40 euro then, the firm will need 2,500 $ to pay 1,00,000 euro , the firm will loose more dollars to pay in euro . The firm has to bear loss because of change in exchange rate.

Exchange rate also affects the price of imported goods and services . Suppose a firm imports all its raw material and has to pay the amount in imported country currency. Any change in exchange rate can increase or decrease the cost of raw materials. it can affect firm adversely or favourably .

Higher exchange rate can also make it difficult for firm to sell abroad. It can decrease firm's export and affect its profit .

If a firm have borrowed money from abroad . Any change in exchange rate can increase or decrease the cost of borrowings .

this is how exchange rate changes affect firms .

Firms hedge exchange rate risks by forward contracts , future contracts , currency options and swaps.

Forward contract is an agreement between a company and a financial institution to exchange a specified amount of a currency at a specified exchange rate on a specified date in future .

Future contracts are similar to forwardd contracts in terms of their obligation, but differ from forward contracts in the way they are traded . Future contracts are sold on an exchange instead of over the counter .

Currency options contracts are of 2 types - currency call option and currency put option .

A currency call option provides the right to buy a specific currency at a specified price within a specified period of time .

A currency put option provides the right to sell a specific currency at a specific price within a specified period of time .

Options offer more flexibility than future or forward contracts because they do not require any obligation . i.e. firm has a right not to excercise the option.