Problem: Discuss types of foreign exchange risk and strategies to address them.
The types of risks may be enumerated as follows:-
i) Transaction risk;
ii) Economic risk;
iii) Translation risk.
Hedging transaction risk - the internal techniques:
1) Invoice in home currency;
2) Leading and lagging;
3) Matching
4) Decide to do nothing;
Hedging transaction risk - the external techniques:
a) Forward contracts;
b) Money market hedges;
c) Future contracts;
d) Options;
e) Forex swaps; and
f) Currency swaps.
Strategies:
Hedging transaction risk - the internal techniques;
Invoice home currency: an easy way is that company insists its foreign customer pay in the company's home currency and likewise the company will pay for all for imports in home currency. But it does not eliminate the exchange rate risk. It has simply been passed on to customers. The adverse effect of it is that the customers may not be too happy and start looking for an alternative supplier.
However the exchange-rate risk has not gone away, it has just been passed onto the customer. Your customer may not be too happy with your strategy and simply look for an alternative supplier.
Leading and lagging: If an importing company foresees that currency in which the payment is to be made may depreciate it may delay in the payment with the consent of the customer/exporter or by extending the terms of the credit. Conversely if the exporter anticipates the currency is likely to depreciate over a period of time it may try to obtain the payment early by extending a discount.
Here the problem arises in guessing which way the movement of the rate will take place.
Matching: if the company's receipts and payment are due in the same currency and at the same time, it can easily match them against each other. Then there remains the problem of unmatched portion of the total transaction necessitating dealing on the Forex markets. One way to overcome this problem is to have a foreign currency account with a bank.
Decide to do nothing: in such situation the company will win or lose some. Theoretically the gains and losses let off to leave a similar result like that of hedged.
While in the short term the losses may be substantial, the additional advantage may be by way of saving in transaction costs.
Hedging transaction risk - the external techniques:
Forward contracts: The forward market is where a firm can buy and sell a currency, at a fixed future date at a predetermined rate, i.e. the forward rate of exchange. This effectively fixes the future rate.
Money market hedges: Here the company deposits/borrows the foreign currency till the date the actual transaction takes place avoiding the uncertainty of the future exchange rate by making the exchange at today's rate.
Futures contracts - The purpose of the future contract is to fix and exchange rate at some future date depending on the basic risk. The future contracts are traded in hedging instruments of standard size.
Options: An option is a right without imposing any kind of obligation to buy or sell a currency at existing price on a future date. In the event of favorable movement in rates the company may allow the option to lapse to take advantage of favorable movement.
The right is exercised only when there is an adverse movement. The difference between call option and put option is that in the case of former the holder has the right to buy the underlying currency and in the latter the holder has a right to sell the underlying currency.
The options are more expensive than the forward contracts and futures.
Companies use options when the need to cover exposure is over a long period of time extending from six to twelve months.
Forex swaps: In Forex swaps the parties agree to swap equivalent amount of currency for a particular period and then re-swap them at the end of the period at an agreed swap rate. The rate of swap and the amount of currency is agreed in advance by the parties hence called a fixed rate or a fixed rate swap. The objective of the Forex swap is to hedge against Forex risk for longer period than on the forward market. Besides it enables access to capital markets from where it may be very difficult to borrow directly - almost impossible.