Question

2) Explain each of the following hedging techniques. Use a hypothetical example that involves an international company trying to reduce or eliminate the FOREX risk of an upcoming financial transaction.

a) Forward market hedge

b) Money-market hedge

Answer 1

a) Forward market hedge

A forward market is a contract entered into between a buyer and seller for future delivery of stock or currency or commodity. The buyer in a forward contract gains if the price at which he buys is less than the spot price and he will lose if the price is higher than the spot price.The forward market is different from the futures market. Futures trade small standardized forward contracts on futures exchanges. Forward contracts set a fixed price and date for future delivery (as do futures) of an asset or financial instrument.

Hedging is an investment strategy whereby various maneuvers may be employed to protect investment value. In financial instrument markets, hedging may take the form of investing in hard-currency securities.

Forward market hedging is a large scale maneuver for a corporation, government or institutional entity to protect a position in the financial instrument or asset markets. For example, if XYZ corporation expects a weakening of a foreign currency that contributes sales revenue, the corporation might protect profits by securing a forward contract for a currency instrument at a profit-compatible fixed price for delivery at a fixed future date. Forward market hedging is a maneuver to protect against loss in the event of a drop in or weakening of assets, interest rates or currency, but hedging is not without risk as an entity in the forward market may find they have over-hedged (creating a liability, or debt) or under-hedged (thus accruing profit loss).

b) Money-market hedge

Short term techniques which are used to lock in foreign exchange rates and cash equivalents. This is typically done by borrowing and lending in multiple currencies to mitigate currency risk (matching currency of assets and liabilities). Money market hedge provides an alternative to forward market hedge at times of unavailability of a forward market or insufficient forward depth for a given currency.

A money market hedge is a technique for hedging foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances, and commercial paper are traded.