Discuss the various hedging strtegies to manage foreign exchange exposure
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Foreign Exchange Hedging Strategies are used for risk management. These are either over the counter (OTC) or exchange-traded products. Most common hedging instruments like forward, options or futures contracts are widely used by traders and corporate alike.
OTC currency forwards involves buying a currency contract at a price set today, for a future delivery. There are two types of forward contracts – outright forward and non-deliverable forwards (NDF). Outright forward contract involve physical delivery of currencies whereas NDF contracts are settled on a net cash basis. Since the price is set on the day of contract, the transaction is said to be fully hedged. But this has the risk of exchange rate moving in the opposite direction which accounts for an opportunity loss.
Option contract is an alternate strategy which is basically a contract wherein entities have agreed to exchange a set amount of currency at a given rate sometime in the future, the entity on one side of the agreement is not obliged to do so, i.e. it has the option to see the contract through or effectively cancel it. This gives that party the option to see through the contract and take the currency at the stipulated rate, or enter the spot market for that currency if its exchange rate is more favorable to that outlined in the option agreement.
These foreign exchange hedging strategies is basically hedging of currency risk. The above products offset or limit the exchange rate fluctuation thereby protecting the company’s investment from the risk of loss. If there is an exposure in multiple currencies, then hedging becomes even more vital
OTC currency forwards involves buying a currency contract at a price set today, for a future delivery. There are two types of forward contracts – outright forward and non-deliverable forwards (NDF). Outright forward contract involve physical delivery of currencies whereas NDF contracts are settled on a net cash basis. Since the price is set on the day of contract, the transaction is said to be fully hedged. But this has the risk of exchange rate moving in the opposite direction which accounts for an opportunity loss.
Option contract is an alternate strategy which is basically a contract wherein entities have agreed to exchange a set amount of currency at a given rate sometime in the future, the entity on one side of the agreement is not obliged to do so, i.e. it has the option to see the contract through or effectively cancel it. This gives that party the option to see through the contract and take the currency at the stipulated rate, or enter the spot market for that currency if its exchange rate is more favorable to that outlined in the option agreement.
These foreign exchange hedging strategies is basically hedging of currency risk. The above products offset or limit the exchange rate fluctuation thereby protecting the company’s investment from the risk of loss. If there is an exposure in multiple currencies, then hedging becomes even more vital
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