Question

Contingent exposure can best be hedged with

A) money market hedging.

B) options.

C) futures.

D) all of the options

and why?

Answer 1

Contingent exposure can best be hedged with options.

Contingent exposure comprise of exposure having impact on cash flow of the firm and its values are not contractually fixed in foreign currency terms.

Contingent exposure encompasses the following instances:

1. An export and import deal is being negotiated and quantities and prices are yet not to be finalized. Fluctuations in the exchange rate will probably influence both and then it will converted into transactions exposure.
2. A firm imports a product from abroad and sells it in the domestic market. Supplies from abroad are received continuously but for marketing reasons the firm publishes a home currency price list which holds good for four months while home currency revenues may be more or less certain, costs measured in home currency are exposed to currency fluctuations.
3. The firm has submitted a tender bid on an equipment supply contract. If the contract is awarded, transactions exposure will arise.

An option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on a specified date, depending on the form of the option.

Hence , Companies may encounter a situation where they may or may not face currency exposure. In this situation, companies need options, not obligations, to buy or sell a given amount of foreign exchange they may or may not receive or have to pay.