Question

What are the three types of hedges a firm can use to protect itself from transaction exposure? Define them.

Answer 1

The three types of hedges that a firm can use to hedge against transaction exposure are: money market hedge, forward market hedge and option market hedge.

Money market hedge - This hedge makes use of the fact that the forward price is equal to the current spot exchange rate multiplied by ratio of the currencies' riskless returns. It converts the fixed obligation to a domestic currency payable and thus, removes any exchange rate risk. It is also known as a synthetic forward contract.

Forward market hedge - If a company is scheduled to receive (or pay) some foreign currency on a future date, it can get into a contract that fixes the price at which it can sell (or buy) the forex currency on the future date. This removes the uncertainty associated with fluctuations in the exchange rate.

Option market hedge - A currency option gives the right but not the obligation to buy (sell) currencies in pre-agreed quantities, time period and price.The main advantage of an option is that the payoff is nonlinear so the downside risk can be done away with and the upside risk can remain intact.