Question

Transaction risk is one of the major risks faced by global business. Assume that you are an exporter of raw materials for the Apple Airpod 2 and you are paid in USD.

1. Discuss approaches that you could take to hedge against currency risk and include the pros and cons of each.
2. What qualitative consideration should you consider? Thoroughly but concisely discuss considerations when hedging this this risk.

Answer 1

Transaction risk is the risk that a company will incur losses in a transaction comprising multiple currencies due to exchange rate movements. This repatriation occurs at a market exchange rate which is vulnerable to fluctuation. These transactions usually comprise a lag between execution and settlement. In this respect, transaction risk is the risk that the relevant exchange rate will unfavorably fluctuate during this lag, resulting in potentially serious losses to the company in question.

Hedging currency risk with specialised ETFs

While less conventional, one way to hedge foreign exchange risk is by investing in a specialised currency exchange traded fund (ETF). In principle, a currency ETF functions just like any other ETF, but rather than holding stocks or bonds, it holds currency cash deposits or derivative instruments tied to an underlying currency, which mirror its movements.

A trader can go long or short on these ETFs, depending on the required hedge, to protect the value of an investment or cash flow from a currency’s (or multiple currencies’) volatility.

Hedging currency risk with CFDs

A contract for difference (CFD) is a derivative that can be used to hedge foreign exchange risk – to open a CFD position, the trader is not required to own the underlying currency. A CFD hedge works because you are agreeing to exchange the difference in price of an asset – in this case currency – from when the position is opened, to when it is closed. If the market moves in the direction the trader predicted, they would profit and if it moved against them, they would lose.

A CFD position can be used to offset the currency exposure of the asset being hedged. Because CFDs are a leveraged product, only a small amount of capital is required to enter the hedge. Furthermore, the hedge can be closed via cash settlement, limiting the potential financial outlay of the trade.

Hedging currency risk with forward contracts

A forward exchange contract (FEC) is a derivative that enables an individual to lock in an exchange rate in the present for a predetermined date in the future. The benefit of a forward is that it can protect an individual’s assets from exchange rate movements by locking in a precise value now. The cost or benefit of buying a forward is known at its purchase, with the forward exchange rate calculated by discounting the spot rate using interest rate differentials.

Hedging currency risk with options

An option gives the right, but not the obligation, to exchange currencies at a pre-determined rate on a pre-determined date. There are two types of options: puts and calls. A put option protects an option buyer from a fall in a currency, while a call option protects an option from a rally in the currency. The benefit of such a strategy is that, for a premium, an individual can protect themselves from adverse movements