Question

State and discuss in detail, the strategy a firm might use to hedge the potential adverse effect (s) of exchange rate changes on the sale of its buildings and machinery located in another country.

Answer 1

On the sale of its buildings and machinery located in another country,.a firm is exposed to foreign currency / exchange rate risk. It might use to hedge the potential adverse effect (s) of exchange rate changes through any of the following mechanism.

Foreign exchange swap

A foreign exchange swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward). Foreign Exchange Swap allows sums of a certain currency to be used to fund charges designated in another currency without acquiring foreign exchange risk. It permits companies that have funds in different currencies to manage them efficiently. A foreign exchange swap consists of two legs: A spot foreign exchange transaction, and a forward foreign exchange transaction. These two legs are executed simultaneously for the same quantity, and therefore offset each other.

Currency rate Swap

Liability in one currency is converted to another currency to address the currency exchange rate risk. The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated.

Short position in Futures or Forward Contracts

If the quantum and timing of foreign currency receivable on sale of office & building is known in advance, the firm can enter into a short (sell) position through futures and forward contract on the underlying foreign currency so that exchange rates are locked today itself.

Put Option Contracts

If the quantum and timing of foreign currency receivable on sale of office & building is known in advance, the firm can enter into a hedge through put option contract on the underlying foreign currency so that exchange rates are locked today itself.