Question

Assume an expected appreciation of the Australian currency. Take the perspective of an Australian multinational corporation involved in hedging a foreign currency receivable. What are the cash flow implications of using future contracts, as opposed to a forward contract in risk management? In answering this question detail the cash flows at the time of entering the contracts and those that are expected to occur over the life of the contracts.

Answer 1

When the Australian domestic currency is expected to appreciate, it will mean that the foreign currency which are receivable to the company will be decreasing as when the Australian currency will be appreciating then the foreign currency will be depreciating so these companies who have entered into hedging contracts will be having a significant advantage of hedging their exposure and they will be protecting the downside of the receivables because they have proactively hedged their receivables in other currency through derivative contracts.

When multinational corporation is using future contract as their risk hedging tool rather than forward contract then,the cash flows which are receivables will be having low amount of counterparty risk and it will also be having a more transparency as this future contracts are generally traded on the exchanges and their rates are highly standardized in nature because this future contracts will not be customised according to the needs of the individuals and hence the cash flow fluctuations will be easily managed because when the cash flows are receivables in future contracts, it will be more liquid as well because they can even square off their contract as these future contract will be continuously traded on the stock exchanges.

Cash flow which are expected to yield from the foreign contracts at the time of entering of contracts will be different and cash flows which will be actually generated will be in adjustment with the foreign exchange fluctuations along with other risk adjustment which will be adjusted in accordance of various transactions as they are expected to occur so these risks cannot be completely predicted in advance and cash flows will be fluctuating.