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Why might firms with exposure to foreign markets use foreign currency derivatives?
Finance & Accounting
Pages 4 (1004 words)
As per Rawls and Smithson (1990), risk management is now employed by many multinational corporations to a large extent that outcomes of surveys showed that financial executives graded risk management as one of their foremost objectives.
A derivative is defined as ‘an instrument whose price is derived from, or depends on, the price of another asset’ (Hull 2009:779). When a company receives foreign currency against supply of services or goods to a foreign based importer, it acknowledges some kind of foreign exchange risk, since there is a possibility of fluctuation between currencies of both exporter and importer from the time of entering into the contract and receipt of funds from the foreign importer. Thus, in case of companies with substantial export earnings, it should assess the quantum of its forex exposure, create a road map for how to minimise that risk, to employ hedging strategies to minimise any substantial loss that may be encountered due to future forex fluctuations in the currencies where it is likely to receive from its foreign importers. (Bragg 2010: 207). For instance, if a company has quoted its export values in US$ and during the interval period where a foreign importer is under obligation to pay the exporter, if the dollar appreciates against the exporter’s currency, then the importer might be paying with a decreased –value currency, which creates the company to account for a foreign exchange loss at the time of receipt of funds. (Bragg 2010: 208). As per Froot, Scharstein and Stein (1993), if the level of capital investment of a company is high, the chance for employing forex derivatives in its risk management policy is always on the increase. (Froot, Scharstein and Stein 1993:1631). ...
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