25 Assume that Bobby Sox, Inc. is thinking about its contingent, cross-border fl

Question

25 Assume that Bobby Sox, Inc. is thinking about its contingent, cross-border flows of funds and the related currency transaction exposure, in which case the exposures are contingent on the Company successfully winning a very large project.Some of the exposures may be inbound flows while others may be outbound flows, but the relative size of each is unknown at this time. Assume these contingent flows (1) occur within the same currency pair, (2) have approximately the same possible timing and (3) are likely not to be in the same amount such that there will be a net inflow or outflow remaining. What do you conclude to be the appropriate strategy to hedge these contingent exposures? Why is that so?

Explanation / Answer

Corporations engaged in international operations are subject to huge risk due to exchange rate fluctuation.

The appropriate strategy in this case will be balance sheet hedging. Under this technique, the balance sheet assets and liabilities represented in foreign currencies are hedged by way of forward contracts with the objective of reducing the risk of exchange rate fluctuation. The on-balance sheet hedging is supposed to be in the same currency, around the same duration and of the same amount. The risk is mitigated because the gains and losses on the derivatives almost offset each other thus protecting the business from any major impact due to exchange fluctuation.

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