Hedging against a Weak Dollar - Essay Example

? Hedging against a Weak Dollar Executive Summary In globalized marketplaces, the necessity to deal in foreign currency is inescapable. The process of acquiring a foreign currency for foreign business activities can be daunting, requiring business forethought and prior contractual arrangements. Currencies change in value all the time, and the process of exchanging a currency for another can be a risky and dangerous process that can cause numerous losses. As a way of preventing losses from currency exchange operations, companies and parties intending to exchange currencies make use of hedging techniques to control and minimize the losses. This paper aims to discuss financial hedging against a weak dollar. A. Euro/US dollar Rate of Euro/Dollar over the last five-year period For the five-year period ranging from 2007 to the end of 2011, the US dollar has experienced numerous fluctuations. The highest value of the Euro in comparison to the dollar was 1.5991, during the 2008 global economic crisis, when American multinationals were going into bankruptcy or requesting bailouts by the government. The lowest value was 1.1923, in the year 2010, two years after recovery from the meltdown. Performance of the dollar against the euro for a five-year period Rate of Euro/Dollar over last year Over the course of last year (2011), the dollar reached its highest and lowest points for the period at the start and at the end of the year. At these times, the dollar was stronger in relation to the Euro. In the middle of the year, the dollar was weaker in comparison to the Euro for the year, and almost reached a rate of 1.5 against the Euro in comparison to the beginning and the end of the year when it was below 1.3 against the Euro. B. Key issues affecting the Euro over the last year Capital Mobility Another short-run determinant to exchange rates between the euro and the dollar is the growing capital mobility across the globe. All forms of financial markets now share access to each other on a global scene, and investors put their money in the markets that offer them the best returns, without restrictions to invest locally. Whenever demand for US assets is bigger in relation to relative demand across the globe, the demand for US dollars will likewise increase. The converse is true, when the demand for US assets falls, investors will have put their money in competing markets rather than the US market, and likewise the dollar will depreciate in comparison, as the investors make the most of the more profitable markets around the globe. Relative price levels A fall in prices causes an appreciation in the currency while a rise in price levels causes a decrease in the value of the currency. For the US dollar to fall in relation to the euro with regard to the price level changes, the goods in the European market would have to fall in prices in relation to the same goods in the American market, or fall at a greater rate in relation to the goods in the European market. A fall in the price of goods indicates a strengthening of the dominant currency in the market. Tariffs and quotas Barriers to trade may significantly affect a currency’s value. The tariffs decrease demand of foreign currency in as a fall in the demand for foreign goods occurs. The result is an increase in the value of the domestic currency. Consequently, the reduction of trade barriers has the reverse effect on the local currency. Enforcement of a quota system for some goods to the European region affects the amount of American exports into the region, which sets a ceiling for the amount in value the dollar can have in relation to the euro over the year. Preference of domestic over foreign goods Increase in demand for domestic goods, exports, causes an increase in the demands of the foreign currency. The converse is true; increase in the demand for the foreign currency causes the domestic currency to depreciate. Increase in demand for domestic goods, for instance, the increase in American made automobiles increase the demand for the dollar, which consequently raises its value in comparison to the euro. Productivity Productivity of a country has a significant impact on the value of the local currency. Increase in the demand for locally production goods acts as a stimulant for production for export. Because of the increase in demand for local goods, the demand for local currency also increases, and the currency appreciates. Consequently, when productivity decreases in relation to productivity in the euro region, the US dollar loses value in relation to the euro since its global demand falls. Short-run currency demands Short run demand for the dollar affects its short-term fluctuations in its value. Short-term demand falls mainly because of changes in demand for financial assets rather than demand for exports and imports from and within a country. The concept explains why a government intervention such as injection of cash into the financial system through quantitative easing, which makes more financial assets into the economy devalues the dollar in relation to the world currencies and especially the euro. C. Appropriate hedging techniques to reduce exchange risk, relevant to the issues above Exchange risk is the inherent risk that a firm assumes when making transactions that involve two types of currencies. Exchange risk can put a firm’s profitability in jeopardy, and many firms are keen to avoid the possibility. Therefore, several measures have come up to help firms avoid the adverse effects of unfavourable currency rate movements. Some methods involve risk and chance, while others offer a balance on the risks and value of the exchanges. . Operational hedging methods Natural hedging In the case of natural hedging, the firm cushions itself against foreign currency turbulences by producing products in the markets it intends to sell them. This way the firm avoids the foreign exchange turbulences as no exchange of currencies is involved in the process. For an American company with operations in Europe, the company would produce goods for European market with its European branches when the dollar is weaker in comparison to the Euro. Through an international production network In this case, the company has many production centers across the globe. Whenever the foreign exchange rates are in favor of the local currency market, making the dollar stronger, the firm can bring imports from its foreign plants to the US market. A stronger US dollar makes US goods expensive in the foreign markets, which decreases their demand; however, it also makes goods manufactured outside the US cheaper. Hence, a country making products outside the US will find it easier to sell to the US market when the dollar is stronger. Likewise, when the US dollar depreciates, it is more profitable for the US to export its goods to the foreign markets. Consequently, production segments of the US multinationals can export goods to international markets. The process shields the companies from adverse foreign exchange rates by giving them the option of selling in the most favorable markets. Financial hedging methods Forward contracts In forward contracts, a US firm, wishing to avoid highly volatile financial market conditions in the future, will enter into a contract, which assures them that they can obtain the currency at a specific price in the future, regardless of the prevailing market conditions at the time. The method has both upsides and downsides. For instance, if a US firm agrees to buy a product several months into the future, and the price of the dollar appreciates, the firm will have to pay more for the product that will be its real price during the time of payment. Consequently, if the value of the dollar relative to the currency decreases, the firm will benefit, as payment for the product will at a markedly lower rate than the market price of the commodity. Therefore, forward contracts act as a form of assurance, because a commodity’s price does not exceed a certain amount in the future, as the price is in certainty several months prior to the payment period. Foreign currency spot contract A foreign currency spot contract is an agreement with a financial institution to buy one currency for another at the market rate. Unlike forward contracts, which can extend to several months in the future, foreign currency spots are evidently immediate. In many cases, the spot rate agreements require the payment of upfront cash. For an American firm requiring Euros, it just needs to contact a financial institution to make an exchange at the market rate. D. Advantages and disadvantages of hedging methods, issues relevant to the currency, which the hedging may address Advantages Forward contract technique Forward contracts offer absolute hedge against adverse changes in a currency in the future. In addition, there is no limitation on the money put in a forward contract deal. In cases where a decrease in the value of the dollar is foreseeable with regard to the euro, a forward contract can be highly beneficial as a company can pay marginally lower for a commodity. Foreign currency spot contract technique Foreign spot contracts are more representative of the real market conditions. The method is applicable for day-to-day currency transactions, for instance, when exchanging euros for dollars. Natural hedging technique Natural hedging helps corporations can diversify and balance the risk in the level of foreign exchange risks adequately without entering into expensive and speculative hedging contracts that may also affect a company’s liquidity. Through an international production network An international production network ensures a company manufactures in places with the best resource usage and profit options. Therefore, the company can exploit the benefits brought about by foreign currency deviations and mitigate adverse currency discrepancies. Disadvantages Forward contract technique In a forward contract, if the local currency appreciates, the payment made to the foreign corporate entity will be larger in value in comparison to the prevailing market rates at the time of payment. In addition, forward contracts ties up capital for a company, which may pose liquidity challenges to the company. Foreign currency contract technique A major disadvantage is that a foreign spot contract exposes the party to adverse currency market turbulences, as currency trades at the market rate. Natural hedging technique Natural hedging can be quite expensive to start at first, with huge capital outlays to get it going. In addition, the trade restriction on the particular country in international trade entities may defeat the purpose of the technique altogether. Through an international production network As with natural hedging, an international production network can be a prohibitively expensive undertaking, which can also suffer because of numerous other autonomous yet hostile economic factors. E. Prospects of the Euro for the next 2 years; appreciation or depreciation, country specific issues, goodness of the place for business, Given the recent trend in the value of the dollar, the rate of the dollar relative to the Euro will preserve its strength over the coming years, with appropriate interventions from the government. Many indications abound that the Euro could easily replace the US dollar as the world’s reserve currency. The Chinese Yuan is also a serious to the US dollar as the world number one currency, although the immediate realities of that are still unapparent. The euro continues to grow, with backing of major world economies and stable economic growths over the years. Since the global economic crisis, the US dollar is slowly losing its grip as the world reserve currency, and has upset the level of confidence many economic establishments had in the currency. The instability of the dollar and its volatility over the last few years has brought to the surface the possibility of relying on a new and more stable reserve currency, with the euro as a prime option. However, the logistical capacities of the dethroning of the dollar by its European counterpart remain a looming reality. Numerous controversies surround the dollar as of today, and unfavorable sentiments emerge from many quarters across the globe. Government measures to reinforce the dollar’s position in the world economic scene raise controversies, which could further dent the dollar’s credibility. For instance, US is making use of quantitative easing, a technique intended to lower the value of the dollar to stimulate local production and the export market for US producers (Davies, 2010). In addition, the US government’s interference in the valuation of the Chinese currency, Yuan has made many Chinese policy makers take hardline and defensive positions against the valuation of their currency. According to some financial analysts, the Euro was going to assume its position as the world reserve currency later this year. With this in mind, over the next two years, and possibly beyond, the value of the euro was going to increase with its increasing demand in the world economic landscapes. Many countries have already actively taken the step, and have made the euro their preferred reserve currency. Notably though, a reversal in the trend in the coming two years could seriously jeopardize the position of the euro in the international currency trade market. References Davies, G. 2010. The Global Implications. The Financial Times. Forex Trading. 2011. ‘Factors affecting the EU economy and the Euro’. Forex Trading. http://www.forextradingplus.com/EU-Economy.htm Allon, G. 2010. ‘Operational and Financial Hedging with the Weak Dollar’. Kellogg Insights. http://operationsroom.wordpress.com/2010/10/21/operational-and-financial-hedging-with-the-weak-dollar/ Read More