Question

MNCs can use several methods to hedge transaction exposure (futures hedge, forward hedge, Money market hedge and currency option hedge).

Give an example of how a particular company hedges the translation exposure (mention which one(s) of these techniques

Answer 1

A hedging transaction is a position that a market participant takes in order to limit risks related to another position or transaction that the market participant is involved in.

FUTURE HEDGE:

A futures contract is an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price.This may not be possible every time. But parties to such a contract attempt to minimise their fluctuation in price risk to the maximum.

For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company's risk because it will be able to close its futures position and buy 20,000 ounces of silver for $11/ounce in six months.

FORWARD HEDGE

Forward market hedging is a means by which to protect exposure in the forward currency, interest rate and financial asset markets.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.

MONEY MARKET HEDGE

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.

This is used for hedging against foreign exchange risk through the money market- which is highly liquid.

How large MNCs ( say a company with large receivable coming in at a future date) use this method:-

1. Borrow the foreign currency in an amount equivalent to the present value of the receivable. Why the present value? Because the foreign currency loan plus the interest on it should be exactly equal to the amount of the receivable.
2. Convert the foreign currency into domestic currency at the spot exchange rate.
3. Place the domestic currency on deposit at the prevailing interest rate.
4. When the foreign currency receivable comes in, repay the foreign currency loan (from step 1) plus interest.

CURRENCY OPTION HEDGE

People who have to exchange currencies at some time in the future use currency options hedges to protect themselves against swings in currency values.

Currency option hedges are often used in international business. For example, an American importer may agree to buy some electronics from a Japanese manufacturer at a future date. The transaction will be carried out in Japanese yen. The American importer creates a hedge by purchasing currency options on the yen. Now, the importer is protected if the yen gains value against the dollar.