Question

1. Now assume the US firm has an account payable of 1,000,000 pounds due in 180 days. Nontechnically describe hedging transactions (or a sequence of transactions) that the firm may want to undertake for each of the following hedging alternatives:

• Forward hedge
• Money market hedge
• Option hedge

Answer 1

Answer:

Hedging- It is the risk mitigating strategy.

Forward hedge- Forward contracts are derivatives contract that buy or sell an asset or security at a specified price and time in the future. Forwards are Customized contracts that trade Over the counter (OTC). Forward market provides hedging facility that can eliminate the future risk and uncertainty.

In the above question, If Firm thinks that Pound will weaken against U.S Dollar then it has to pay more pounds. So it will enter into 6 months forward contract, in whcih-

It will go long and buy the Pounds by selling U.S dollar in the forward market and after 6 months on a specified date when Value of Pound will go up (As it will depreciate against U.S dollar), it will convert the U.S dollar into Pounds and will make the payment.

Money market hedge- When future receivable or payable are hedged with the help of money market. Money market is a financial market where short term financial instruments like commercial papers, Treasury bills, banker's acceptance are traded. Money market hedge is used in Transaction exposure.

How to hedge in Money market- In the above question in which U.S Firm has an account payable in Pound, that is a foreign currency for USA, Firm will do the following:

1. It will borrow the domestic currency in an amount equivalent to the present value of payment.
2. It will convert the dollar into pound at the spot rate.
3. It will deposit the pound.
4. When the deposit of pound matures, it will make the payment in pound.

Option Hedge- Options are the derivative contracts, they are mainly of two types, Call and Put. Call is the right but not the obligation to buy an assets at the specified time and price in the future and Put is the right but not the obligation to sell an asset at the specified time and price in the future.

Hedging with Options- Hedging strategy in Options is used by entering into two positions. In Option, Call and Put are used for hedgind.

In the above question, If Firm is thinking that Pound will weaken against Dollar, It means, Pound will have more value when converting into dollar in the future so firm can buy the Call options of Pound against dollar, Call is bought when trader is bullish towards a particular security, as the Value of pair of Pound & Dollar (GBP/USD) will increase, call premium will also increase and firm can sell the call and get the profit.