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Analytical Application - Essay Example

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Each hedging strategy has its own pros and cons. This analysis explicitly focuses on the use of currency future contracts as a hedging strategy to mitigate the likelihood of adverse foreign exchange movements. There are three scenarios that are highlighted in the following discussion. 1. Hedging against Payables Currency future contracts allow organizations to trade in the respective currencies in which payments and receipts are to be made. These currencies are traded in the form of contracts such that each contract is composed of certain units of a particular currency. In this scenario, the currency is the Euro and the reference currency is assumed to be US Dollars. Therefore, one contract of Euro consists of €125,000. So in order to hedge the payment of around €500,000, the number of Euro contracts required for hedging are 4 i.e. (€500,000/€125,000). In case of payment, the standard hedging strategy would be to buy four Euro future contracts expiring in June as the conventional period of contracts is three months such that March, June, September and December future contracts are available for trading. As the payment is to be made in three months from now, therefore, June future contract would be the most suitable contract in this regard. The current spot price is €1=$1.3167 and the Future June Contract price is €1=$1.3114. Therefore, the organization will be facing the danger of Euro currency to be more expensive in the future against the US Dollars such that it will have to pay more US Dollars for the payment of €500,000. In this case, the appropriate hedging strategy would be to buy four Euro currency futures contracts and sell them at the time of actual payment. Assuming that if the spot price after three months increases, it will result in a gain for the future contracts that the organization has bought earlier but simultaneously, the increasing spot rate would result in the loss in the actual cash transactions of buying €500,000 at a higher price. In this way, the gain realized from the future market will offset the loss that would be incurred in the actual purchase of Euro currency. If the situation turns the other way round and the spot rate of Euro decreases, then there would be a loss in the future contracts that organizations had bought three months earlier, but simultaneously the organization will have to pay less US Dollars to purchase €500,000. In this case, the loss suffered in the currency future market will be offset against the gain that organization experienced as a result of decrease in the Euro spot rate after three months. Hence, in this way, the organization will be safeguarding itself for any volatility in the foreign exchange rates (Herbst et al 1992). 2. Hedging against Receivables A similar strategy would also be applied in the case of receivables such that the number of contracts to be traded is now eight as the total amount to be hedged is €1,000,000 and the size of the contract is €125,000. Since the case demands that the amount is going to be received, therefore, the biggest danger in terms of Euro currency fluctuation would be that the Euro might become cheaper such that it would earn less US Dollars if the spot price of Euro slips in three month’s time. Therefore, as part of the hedging strategy for the currency future contracts, 8 June future contracts should be sold short and then buy them back after three ...Show more
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Analytical Application In case of imports and exports, the biggest danger that organizations generally face is that of adverse movement of the exchange rates. Since the payments and receipts are normally due in the near future, therefore, organizations do not have any control over the foreign exchange rates…
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