Question

I need answer for the second part of the question (in detail). Thanks.   Explain how leading and lagging foreign currency cash flows can mitigate currency risk. What are limitations to this method?.

Answer 1

Leading and lagging.

It refers to the adjustment of the times of payments that are made in foreign currencies. Leading is the payment of an obligation before due date. Let’s imagine you are planning to go to USA and you believe that the Dollar will strengthen against your own currency. It might be wise for you to change your spending money into Dollar now. That would be ‘leading’ because you are changing your money in advance of when you really need to. Lagging is delaying the payment of an obligation past due date.Let’s say, however, that you believe that the Dollar is going to weaken. Then you would not change your money until the last possible moment. That would be ‘lagging’, delaying the transaction.

The purpose of these techniques is for the company to take advantage of expected devaluation or revaluation of the appropriate currencies. Lead and lag payments are particularly useful when forward contracts are not possible.

Limitations :

Leading and Lagging are related with foreign exchange loss or gain on transactions which are already entered into and which are denominated in foreign currency when exchange rate changes. These type of exposure is concerned with changes in the present cash flows of the firm.