In this session we discuss concepts of international finance - specifically the

Question

In this session we discuss concepts of international finance - specifically the payment cycles, risks and currency. When it comes to currency related risks, businesses can utilize three types of hedges to protect themselves from transaction exposure. Select a currency (other than USD) and determine which hedging technique you would use if you were enter a business transaction today with a new partner in that country. Explain the type of relationship (supplier or customer), the currency, and why the hedge technique was selected.

Explanation / Answer

Answer : Foreign investment brings with it two exposures included one the underlying asset and the currency.By developing a currency hedging plan one can manage the currency risk separately.There is no way to guarantee that the price in the currency market will be the same in the future ,it is possible that the price will move against the company,making the payment cost more on one hand and market can also move in favour of the company making the payment cost less in terms of their home currency.Generally firms exports goods to other countries benefit when their home currency depreciates,since their products become cheaper in other countries. Firms that import from other countries benefit when their currency become stronger,since it enables them to purchase more.

Normally we use three types of hedges to protect ourselves from transaction exposure.The following are the three types of hedges we use.

1.Currency futures & forwards

2.Currency options

3.Currency swaps

Suppose, an US company has to pay AUD 5 million to an australian supplier with in 90days because it has purchased materials worth AUD 5 million from an austrilian supplier today.It is concerned about a depreciation of the USD against AUD in the near future. so because company is expecting depreciation in home currency it is better to enter in to forward contract for the size of $5 million with maturity period of 90 days.so there will be no uncertainity regarding the payment to supplier after 90 days.

Underlying position : short AUD 5million.

  Hedging position : Long 90 days futures for AUD $5million

In some conditions when US company was unable to predict the future regarding decrease or increase in value of home currency against value of AUD,however it wants to insure itself against any transaction risk it is better to buy an option which will give a right to buyer but not an obligation to buy or sell some currency at a specified exchange rate on a specified rate or on 90th day or payment day.suppose current exchange rate $0.74 and we have bought a option at $0.74 which on maturity date turns out to be $0.73 and buyer of option would exercise the option if it is 0.75 or more buyer of option wont exercise the option.

There is no such difference between swapations and options . options are used for hedging short term transaction payments.while swapations are used for hedging long term transaction payments.

If the US company can expect the exchange rate after 90 days or on payment date,it is better to take forward cover now for payment with in 90 days if favourable terms exist.

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