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Why might firms with exposure to foreign markets use foreign currency derivatives - Coursework Example

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Why might firms with exposure to foreign markets use foreign currency derivatives

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). ...
ers of the international companies opt these derivatives so as to take the positions in the anticipation of revenues (speculation) or employment of these instruments to minimise the risk inherent with day to day management of their company’s cashflow hedging).( Aswathappa 2010 :543). The probable advantages from employing forex derivatives are reliant on the anticipated exchange rate movements. Thus, it is essential to comprehend why the exchange rate moves over time before employing the forex derivatives for risk coverage. Different Kinds of Forex Derivatives Forex Forwards: Forward is comprised of spot transactions that have been retained for less than 180 days but held over 48 hours when they due for payment and paid at the current prevailing spot price. If you minus the bid price with that of ask price, then you can arrive at the transaction cost. Forex swaps are financial transactions associated with the swapping of two currency amounts on a particular date and a reverse exchange of the analogues' amount at an afterward date. The main objective is to administer currency risks and liquidity by executing forex transactions at the most apt time. In fact, the underlying currency is borrowed and lent concurrently in both currencies, for instance, by selling Euro for US$ for spot value and consenting to reverse the deal at an afterdate. (Brickford& Brickford 2007:7) Forex Futures: A future can be illustrated as a standardised contract to sell or buy a particular asset at a price previously consented to and at a fixed future date. Forex futures are standardised financial instruments that are negotiated in organised markets. Forex futures have many probable benefits but also have many probable risks. Forex futures markets are not only heavily regulated but also ...Show more

Summary

Introduction
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.
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Why might firms with exposure to foreign markets use foreign currency derivatives essay example
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