One of the popular misnomers about hedging is that it is a costly, time-consuming, complicated process. But it's just a misnomer!
What is financial hedge?- Natural Hedging and Financial Hedging are the two common types of hedges. Some companies will use both these methods in order to be safe from currency risk.
Natural hedging involves reducing the difference between receipts and payments in the foreign currency. Take the case of a New Zealand firm which exports to Australia and happens to forecast a return of A$10 million. Over this period, it expects to make several payments totaling A$3 million; the New Zealand firm's expected exposure to the Australian Dollar is A$7 million. In case the New Zealand firm borrows A$3 million they can also use natural hedging techniques to acquisition of materials from Australian suppliers by A$3 million as well. Now, the New Zealand firm's exposure is only A$1 million. By eliminating all transaction costs, this New Zealand firm could even open production in Australia.
This is why you need financial hedging- Banks buying and selling foreign exchange instruments and foreign exchange brokers need to be involved in Financial Hedging. There are three common types of instruments used: forward contracts, currency options, and currency swaps.
Usually Forward contracts help with future buying or selling of foreign currency. Entering a forward contract is possible if a New Zealand firm expects to receive A$1 million in excess of what they are supposed to spend in that quarter and they can get a predetermined rate for Australian Dollars every three months. Almost all of the transaction costs can be eliminated by offsetting the A$1 million with the help of forward contracts.
If a firm doesn't have solidified plans and is bidding on a contract, they will find favorable currency options. Just because a firm gets a specified exchange rate and date for buying or selling of currency in the future, doesn't mean its an obligation. There are of course upfront costs to deal with when it comes to currency options but it is these costs that give these small and medium sized firms favorable exchange rate movement. To hedge against interest rate risk, a firm needs currency swaps which are long term hedging techniques like interest rate swaps. Financial hedge can make you more profits!
Exchange rate volatility can affect a company's hedging strategy - the next post will cover why timing is key.
What is financial hedge?- Natural Hedging and Financial Hedging are the two common types of hedges. Some companies will use both these methods in order to be safe from currency risk.
Natural hedging involves reducing the difference between receipts and payments in the foreign currency. Take the case of a New Zealand firm which exports to Australia and happens to forecast a return of A$10 million. Over this period, it expects to make several payments totaling A$3 million; the New Zealand firm's expected exposure to the Australian Dollar is A$7 million. In case the New Zealand firm borrows A$3 million they can also use natural hedging techniques to acquisition of materials from Australian suppliers by A$3 million as well. Now, the New Zealand firm's exposure is only A$1 million. By eliminating all transaction costs, this New Zealand firm could even open production in Australia.
This is why you need financial hedging- Banks buying and selling foreign exchange instruments and foreign exchange brokers need to be involved in Financial Hedging. There are three common types of instruments used: forward contracts, currency options, and currency swaps.
Usually Forward contracts help with future buying or selling of foreign currency. Entering a forward contract is possible if a New Zealand firm expects to receive A$1 million in excess of what they are supposed to spend in that quarter and they can get a predetermined rate for Australian Dollars every three months. Almost all of the transaction costs can be eliminated by offsetting the A$1 million with the help of forward contracts.
If a firm doesn't have solidified plans and is bidding on a contract, they will find favorable currency options. Just because a firm gets a specified exchange rate and date for buying or selling of currency in the future, doesn't mean its an obligation. There are of course upfront costs to deal with when it comes to currency options but it is these costs that give these small and medium sized firms favorable exchange rate movement. To hedge against interest rate risk, a firm needs currency swaps which are long term hedging techniques like interest rate swaps. Financial hedge can make you more profits!
Exchange rate volatility can affect a company's hedging strategy - the next post will cover why timing is key.
About the Author:
HedgeBook is an evaluation and reporting tool used for option pricing by financial managers and corporate treasurers. If you do Hedge accounting, HedgeBook is a must have.
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