The Concept of Currency Hedging - Essay Example

Firms do not make use of all the available currency hedging techniques during a given period at the same time due to the following reasons:
- In the first instance currency hedging practices have their relative individual significance vis-à-vis non-currency investment opportunities and net returns on such investment vehicles (Zarin, & Zimmerman, 2006). For example, investors bank their hopes on relative net returns such as Net Dividend Yield (NDY) generated by stock-related investments. Thus potential investors look at how the growth trajectory of Net Asset Value (NAV) would increase in keeping with net returns in relatively less risky spheres of investment.
- Secondly, the risk factor associated with currency market-related investments is proportionately higher when foreign exchange-related investments take a plunge due to uncertain government policies. For example, if the government concerned allows its own currency to depreciate externally to correct a deficit in the trade balance of the balance of payment, investors would be caught on the wrong foot if they happen to bank their hopes constantly on the continuity of government policy (Maskey, 1995).   
- Thirdly the government may adopt anti-inflationary measures such as higher corporate taxes and expenditure taxes. The net result would be less investment and less borrowing. Currency markets become dormant during such periods of negative policy initiatives.
- Foreign exchange rates and interest rates are positively related because when interest rates fall the exchange rates also fall because potential foreign investors do not buy the domestic currency concerned for investment when the domestic interest rates fall and as a result, the demand for the domestic currency abroad falls thus leading to an unfavorable exchange rate (Larsen, & Resnick, 2000).
- Hedge funds, mutual funds, pension funds, commercial banks, and other money market players tend to hedge risk by minimizing the degree of exposure to adverse consequences arising from unfavorable exchange rates, inflation, and investment-related uncertainties such as a continuous fall in stock prices (Biger, & Hull, 1983).
Currency hedging has become a very controversial issue in modern money market operations (Adler, & Prasad, 1992). Commercial banks and other market players have adopted highly strategic exclusive policy initiatives to deal with the problem. This paper investigates the relative efficacy of such highly complex approaches to currency hedging adopted by different market players, while at the same time focusing attention on the doubt expressed by modern writers about the benefits of currency hedging strategies to all market players at a given time.
Currency hedging is a technique that is meant to manage and reduce the risks involved when engaging in some foreign investment strategy. Essentially the very nature of a currency hedging effort would be more beneficial in obviating the negative outcomes from any shifts in the relative value of the currency as utilized in the investment process (Levy, & Lim, 1994).