Business Corner 20

Training on business, accounting, internal control and audit

Hedging techniques

Hedging techniques:

 – internal hedging techniques

- external hedging techniques

(1) Internal hedging techniques

- invoicing in the home currency

- bilateral and multilateral netting

- leading and lagging

- matching

- restructuring

Restructuring:

- the firm can reduce its long-term exposure to exchange rate fluctuations by restructuring its operations

- may involve:

(i) increasing or reducing sales in new or existing foreign markets

(ii) increasing or reducing dependency on foreign suppliers

(iii) establishing or eliminating production facilities in foreign markets

(iv) increasing or reducing the level of debt denominated in foreign currencies

(2) External hedging techniques

- forward markets

- option forward exchange contract

- money market hedge

- futures

Options:

- give the client the right, but not the obligation, to buy (“call”) or sell (“put”) a specific amount of currency at a specific price on a specific date

Money market hedge:

- to hedge payments in a foreign currency, one would borrow at home, which would then be changed into the required foreign currency and invested until the payment is due

Futures:

- financial futures in foreign exchange rates are contracts to buy or sell an amount of foreign currency at a future date, and are traded on futures exchanges such as the Chicago Mercantile Exchange

The level of premium depends on a number of factors:

- the strike price

(i) “at the money”: the agreed price corresponds with that currently available (spot or forward)

(ii) “in the money”: the agreed price is more favourable to the client than is currently available (the premium would be higher)

(iii) “out of the money”: the price is less favourable to the client than is currently available (premium would be low)

- the maturity

- the volatility of the spot rate (the greater the volatility, the greater the premium)

- interest-rate differentials

- liquidity in the market

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Author: businesscorner20

A consultant and a lecturer, with experience in business administration, accounting, internal control and audit.

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