Question

We fear a revaluation of the currency of our affiliate the Malaysian ringgit. Explicate how we should hedge our translation exposure through a balance sheet or forward hedge.

Discuss the implications of our hedging actions.

Answer 1

Country with High Inflation rate usually experience higher Depreciation hence Hedging is necessary to reduce the risk arised from Global market. For example Malaysian Ringgit experience high inflation compared with USD currency.

USD currency is picked just for Example.

To reduce exchange rate risk, currency Swap is a solution(Forward contract) own as a cross-currency swap, is an off-balance sheet transaction in which two parties exchange principal and interest in different currencies. The parties involved in currency swaps are generally financial institutions that either act on their own or as an agent for a non-financial corporation. The purpose of a currency swap is to hedge exposure to exchange rate risk or reduce the cost of borrowing a foreign currency.

A currency swap is like an interest rate swap, except that in a currency swap, there is often an exchange of principal, while in an interest rate swap, the principal does not change hands.

In currency swap, on the trade date, the counter parties exchange notional amounts in the two currencies. For example, one party receives 4.27 million Malaysian ringgit, while the other receives $1 million U.S. dollars (USD). This implies a USD/MYR exchange rate of 4.27. At the end of the agreement, they will swap again using the same exchange rate, closing out the deal.

When we speak about hedging transaction implication, The currency swap market is one way to hedge that risk. Currency swaps not only hedge against risk exposure associated with exchange rate fluctuations, but they also ensure receipt of foreign monies and achieve better lending rates.