Question

What is a cash flow hedge of a foreign currency receivable?

Answer 1

Corporate having global business is normal now a days. Doing business globally involve multicurrency (Currency other than base or local currency). As import export will need to be settled in other party currency. Branch operation also lead in forex exposure. There are lots of ways to hedge against the foreign currency. Let’s explain this from example.

If a US firm is exporter of garment to UK and UK entity is paying US firm for purchase of garment, payment term 60 days. US firm will have fear of USD appreciation against the pound. At the time of sale say 1 pound = 1.3 USD, but after 60 days currency may change. In such event of uncertainly US firm would like to hedge its foreign currency receivable. Below are the few financial instrument thru which hedging can be done-

1. Forward agreement : Forward agreement is agreement between two parties to exchange predetermined amount of asset at future date. Under forward agreement US firm can lock its forex exposure by entering into agreement with counter party to exchange Pound receivable with US receivable. By doing this US firm will not have any future risk of currency movement. When actual payment in pound received from UK entity, US firm will exchange this amount for USD under its forward agreement. These contract are over the counter and their exist possibility of default risk of counter party.
2. Currency Future or option : Currency future or option can be used to hedge forex exposure. These are more or less similar like forward contract except that these contract are standardized and less default risk of counter party as exchange serve the counter party.