The four financial hedging techniques are future, forward, money market and currency option hedge. Any business firm is supposed to compare it is the cash flow in determining which the technique to apply to hedge. The futures hedge is involved in the use of the currency futures. To hedge the future payables, the business or the associated firm is supposed to purchase a future currency contract in regard to the currency of the choice as it needs (Stephens, 2003).
A forward hedge is the similar with the future hedge but the only difference is that the only forward contract it needs but not the future contract. Both are of the future exchange rates where the company involved buys and sell the currency. The risk aspect depends with the firm in measuring at what level to avoid it by putting the required mechanisms of risk aversion (Chorafas, 2007). This is to hedge or no to hedge the decision comparing to the results of the study of the earlier results of hedging.
If the decision of their result is negative, then should apply hedging to reduce the chances of risking. In the computation of the real cost of the expected value, the probability distribution of the future spot rate is done to be used in the hedging (Greenhill, 2012). Therefore, if forward rate unbiased in the probability distribution, then the prediction would be unbiased leading to the real cost be zero in hedging. The money market hedge deals with taking one or several positions in the money market, therefore, helping to cover the exposure to the risks (Rao, et al., 2007). This is preferable by the risk aversion dealer for the chances of risks are low.
A currency option hedge usually uses the currency calls or the put options to hedge transaction exposure. Hedging techniques are comparable by focusing on the minimal payable cash flows and the maximum receivable association with the currency option. This is where the minimizing the payables and maximizing on the receivable are compared with the cash flows that are associated with the currency options while hedging and without hedging (Batten, et al., 2013). This leads to the hedging policies that depend on the firm's management risks aversion level and how they forecast the exchange rates. This decision is made in a way if it is to hedge the most risk exposure, none of the risk exposure or selectively hedge the risk exposure depending on the management strategy and their decisions.
There are three hedging techniques that are most preferable for the long term hedging. They are long term forward contracts, currency swap, and the parallel loans. To start with is a long-term forward contract also known as long forward. Its maturity is of ten years or extra according to the contract signed by the both parties. This can be set up by any creditworthy client as far as the terms and conditions are met (Hussain, 2000). Currency swap is of many forms. This is made by the two parties with the help of the broker as the witness, as they agree on exchanging specified amount of the currencies in the future date specified in the agreement (Wilson, 2010).
Parallel loan, also known as the back to back loan, it is concerned with the exchange of the currencies by the two parties. The after agreed on time they re-exchange back at a specified future date with a specific exchange rate. The limitation of the continual hedging is that, in the long run, the repeated transactions causes’ limited effectiveness (Saunders & Cornett, 2011). This is as a result of the forward rate which often tends to move in tandem as and with the spot rate. This affects the importers who usually use one time contract of the forward hedging continually. They eventually pay prices that are higher at times of strong foreign currency cycle.
The use of the derivatives to manage the currency risks
Derivative being an instrument whose structural characteristics include the timing of the cash flows are used as the basis of managing and controlling the currency risks (Loader & Biggs, 2002). Its structural variables include maturity and the expiration dates, credit, repayment, valuation and the exchange rate risks. The derivative instrument includes forward, futures, options, swap, caps, ceiling, and floor among others. The active derivatives in the markets are treasury bills, note, bonds, mortgage backed securities, equity securities and global currencies among others. These are the derivatives that are commonly used by institutions and the firms in the financial field.
The use of the derivatives has two main reasons within the management of the risks. To begin with are the high and variable levels of the market volatility. These have made the risk aversion firms and the individual participant to widely employ the derivatives as the shock absorber. The volatility of the business as it is faced by many number of the risks. The derivatives help to manage the risks thus reducing the chances of exposure (Olson & Wu, 2008).
The second reason of employing derivative is due to the limited ability to adequately manage the risks exposure. This is done by just using the policy decision on the cash market transaction. The risks exposure to the financial institution is many from the currency devaluation and the unexpected change of the exchange rate. This makes the risk aversion financial dealer is it be a financial institution or person to go for derivative as an option (Alizadeh & Nomikos, 2009). Hedging using derivatives employs the following four instruments. Foreign currency futures, foreign currency swap, foreign currency options and the foreign currency forward contracts.
In the use of the derivatives to manage the currency risks, the above instruments are used. Position that is not hedged leads currency to rise hence risks are high (Bellalah, 2010). In that position is referred to as an open position on the currency at the target. If there is more selling of the foreign currency than the way they are purchased, then the situation is considered to be net short in the same currency (Booth, 2012). At this position, the risk is also high and may cause the foreign currency to fall in value leading to the risk of loss.
A bank being the financial institution that controls the derivative use in a way of managing the foreign currency has a major role in the balancing the local currency. When the foreign currency risk exposure is high that means the local currency is also at risk and vice versa (Dempster, 2002). Therefore, the banks come into control so as they can be in a level that has the minimal risk exposure. The net foreign currency exposure provides with the information of how the exchange risk has been underrated by the particular bank at the same period (Chaplin, 2005). This show how that particular point the currency was not hedged and make it open and exposed to the risks.
In the exchange rate, sometimes is affected by the fluctuation in the real time. This makes the exchange rate volatile. This then measures the level at which the fluctuations varies over a specified time. The volatility is frequent when there is up and down and less when changes take time over a period (Tracy & Smith, 2010). This is when there is lesser frequency of up and down in the currency exchange. The foreign exchange risk management is done when an institution or bank is dealing with the foreign currency. This is the time the currency transactions are made on behalf of the customers. At this point, the risk is transferred to the client because the institution has no exposure to risk thus the client has to bear the burden (Jalilvand & Malliaris, 2012).
When it comes to the foreign exchange risk, the mitigation is made using special and different hedging techniques. This hedging technique includes foreign currency asset and liabilities matches. This is where the particular commercial bank matches the assets and the liabilities in foreign currency (Hull, 2007). In employing this method, the positive profit spread is met depending on any movement of the exchange rate in the market. Finally, the currency and the exchange rates are the things to consider in the entire hedging processes. The level of the risk exposure depends on how unstable the currency is and the mitigation strategies the financial firm is applying to correct the situation.
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