Question

Which of the following hedging techniques insulates a firm from adverse exchange rate movements, and yet allow the firm to benefit from favorable movement?

	A.	forward hedge
	B.	futures hedge
	C.	option hedge
	D.	money market hedge
	E.	all of the above

Answer 1

The hedging technique that insulates a firm from adverse exchange rate movements, and yet allow the firm to benefit from favorable movement is Option Hedging that is option C.

Suppose, there is a company A who wants wants to cover itself against any kind of exchange rate movement. Suppose, the company has its subsidiary in India and wants to have a hedge for the earnings that needs to be bring back to domestic country. Assume Company A is a US company and hence the hedging needs to be done on USD-INR Currency Pair. Assume that the spot rate of USD-INR is 69. Here the company will go for a hedge at say 69 itself so that the company can be sure that the exchange rate in future will be 69. If the company goes for future or forward, then it needs to be performed irrespective of being a net gainer or net loser. I

f the company has the option, then company will have the right and not the obligation to perform the duty. Suppose on the expiry, the USD-INR pair exchange rate is in company favour, then company will not exercise it and will pay only a small premium amount and hence the loss is limited to the amount of premium paid. On other hand, if the currency rate is not in favor then the company can exercise the option and earn a huge profit. Hence in this strategy, gains is unlimited and loss is limited.