International Finance and Banking - Hedging

International Finance and Banking – Hedging

Introduction

When a company has negotiated an agreement to pay or receive a certain fixed some of foreign currency at a future date, it can obtain a written contract that specifically specifies the price that it will buy or sell that particular currency at a specified future date. It basically converts the currency value of his asset or liability that was uncertain to a certain home currency value that will be received on a certain specified date despite the changes that may affect the currency exchange rate. These are known as Forward market contracts.

Money market Hedge are basically known as the synthetic forward contracts and they utilize the covered interest parity which stipulates that the forward price must always be equal to the current exact spot exchange rate multiplied by the calculated ratio of the home and foreign currencies returns that are not risky. It can also be viewed as a financing of a foreign money or currency transaction. This process converts the liabilities or assets payable or receivable in a fixed home currency and completely removes all the exchange rates risks. (Albuquerque, 2007)

If the company needs some short term financing of its debts or if it’s interested in paying off other loans with higher interests rates or it has some extra cash then the utilization of the money market hedging is the best option than the forward contract. (Hagelin and Pramborg, 2004)

Foreign currency options basically known as options are contracts that involve upfront fees and which entitle the owner not to trade but to retain a specified quantity of foreign currency at specific price and over a certain period. There are several variations of options that are available i.e. the puts and the calls. The major difference between options and the other forms of hedging is that options are non – linear.

The hedging techniques that Yankee could gain from are the options payoff price and particularly not the sport price but the use of the average price which should be spread to cover the entire period of the contract. Yankees contract is relative stable and its source of revenue is relatively stable. An average rate option will mostly act as a useful hedge for most of the transactions. The company can also lock and agree on an average rate option over a specified period for a strike price of a particular option. Since the average is normally less volatile than the alternative end period rate. (Brookes, Hargraves, Lukas and White, 2000)

Finally to conclude, the more efficient markets while under various assumptions like risks neutrality, the hedging contracts should mostly be priced to gain a net present value of zero. Contracts that don’t receive or pay more upfront like the forward and the future contracts will certainly have the expected payoff but the other alternatives like the options approach will have a payoff that’s equivalent to the front premium. Options are like insurance as they provide some form of insurance to the owner of the business. They basically provide guarantee against some losses that have been preset.

References

Albuquerque, R. (2007) Optimal Currency Hedging, Global Finance Journal, 18 (1), 16- 33.

Brookes, A., Hargraves, D., Lukas, C. and White, B. (2000) Can Hedging Insulate Firms from Exchange Rate Risks? Reserve bank Of New Zealand Bulletin, 63 (1) March 21-34.

Hagelin, N. and Pramborg, P (2004) Hedging Foreign Exchange Exposure: Risk Reduction from Transaction and Translation Hedging, Journal of international Management and Accounting, 15 (1)