How Firms Use Financial Hedging to Manage Currency Risk - Literature review Example

How different size of firms using financial hedging techniques such as Forwards, Futures, Options and Swaps to manage currency risk Contents Introduction 3 2.Critical evaluation of all relevant hedging techniques used by large firms or multinational companies 4 3.Critical evaluation of all relevant hedging techniques used by small firms 6 4.Comparison of the similarities and differences of the use of the hedging techniques used by large and small firms 8 5.Conclusion 9 References 11 1. Introduction The dealings that is carried out by the countries in relation to the trade and finance and the international investment which is related to the parties that are unwilling to bear the foreign exchange risk and it is very important and significant for the businesses to manage the risk that is related to foreign exchange which will facilitate the business to concentrate and focus on the eliminating and reducing the risk. The various financial hedging techniques are the forward rates, options, swaps and futures. The market that deals with the options and futures are also known as the derivative market. The topic mainly emphasizes on the hedging techniques that is required for managing the risk. While conducting international trade operations it has been observed that foreign exchange plays an important and significant role. The techniques of hedging generally facilitates the firms that are active in the international market to reduce or minimize the exposure towards the variation in the foreign exchange rate which could adversely and severely affect the value of the asset and profit margin of the business. With the presence and the existence of the derivative market it facilitates and assists the business in management of risk, arbitration and speculation in the derivative as well as the spot market. The topic also emphasizes or deals with the various financial instruments such as the foreign currency debt and the derivative related to foreign exchange which helps in neutralizing the risk and the topic also highlights the various benefits and limitations of the management strategies of the various exchange rate risks. 2. Critical evaluation of all relevant hedging techniques used by large firms or multinational companies The author Cowan in his study has emphasized on hedging the financial risk that is mainly faced by the large or the multinational companies is by hedging its risk by the financial product forward. The multinational companies generally prefer hedging through the foreign currency loans and the operational hedging. The forward contract is mainly arranged and dealt by explaining and customizing the agreement or the deal that is carried out between the parties for fixing and determining the exchange rate for carrying out the transaction in future. The arrangement is conducted in such a way that it will eliminate the risk related to foreign exchange. There are also disadvantages related to hedging with forward contract which is related or associated with fixing the amount at a future rate. Entering into the forward agreement or contract can be explained as the method of transferring or passing of the risk to the banks that are responsible for bearing or handling the risk. Hedging with forward can be explained with the example of the business that is carried out in Malaysia which explains that by entering into the forward rate agreement the businesses mainly transfers the foreign exchange risk to the banks and sometimes the risk is more severe in nature than the banks transfers some of its risk to the third party. This can be explained with reference to the construction company in Malaysia which has undergone a contract for the construction of road with the amount of Rs 10,000,000 in INR. But in order to overcome or avoid the depreciation in the currency the company has entered into a forward contract that includes or comprises of the legal obligations that is required to be abided by both the parties. In case if the currency appreciates then the risk has to be fully borne by the bank therefore there is a presence of a speculator in the financial market which performs or functions the role of the counter party position. The construction company of Malaysia by entering into the forward agreement or contract the company is confident with the stability in the exchange rate and is assured that it will remain safe and protected even if the exchange rate depreciates. And if the currency at which the deal is finalized appreciates then the company has to bear some amount of favourable loss (Cowan, 2005). The authors Shapiro and Glicksman in their study have focused on the favourable movement is being considered and regarded as the potential loss. The large and the multinational companies also deal with the financial product futures or the hedging contract or the agreement that deals with futures. The future market generally overcomes the disadvantages or the limitations of the forward market. The market that deals with the future technique establishes a contract or agreement or contract between the seller and the buyer and urging or forcing them to buy or sell the currency at a particular specified date in future. The future contract is considered and regarded as a legal contract similar to the technique of forward contract or agreement (Shapiro and Glicksman, 2004). Reesrachers Ruozi and Ferrari have focused on the main advantages or the benefits of the future contract are the future contract is mainly traded in the central market and it increases the liquidity. The future contract has the advantage or the benefit of easily and early closed out by entering into an opposite transaction, the approach that is related to the future contract is subjected to expiration. The spot price and the future price have the tendency to converge and leverage which is considered as an important feature of the future contract and this facility of leverage usually allows or facilitates the trader for hedging big or large amounts with relatively smaller outlays. The future contract can be explained with the example such as if anyone plans or decides to plant 400 bushels of wheat in the coming year then the person can either opt or select to grow the wheat and sell it at a price that is available in the market at the time of harvest or he can opt or decide to select a price at present date by selling the future contact at a fixed and specified price after harvesting it (Ruozi and Ferrari, 2013). 3. Critical evaluation of all relevant hedging techniques used by small firms Researcher Khatta in his article has practised on hedging technique that is adopted by the small firms is the application of financial hedge. The smaller firms or the businesses mainly prefer to hedge with the expectation of increasing a high degree. The smaller firms generally adopt the technique or the strategy of option for hedging against the exchange risk. The use of the option hedging is entered into between the buyer and seller. The buyer of the option possesses the right either to buy or sell the particular currency at a specified date and specified exchange rate from the seller of this option. The smaller firms generally deal with the options which are of two types such as the put and the call option. The put option generally facilitates the buyer to buy the currency at a particular exchange rate before or after a specified date and the put option which provides or facilitates the buyer to sell the particular currency at a specified date. The options are generally applied at the time of bidding. When the bidding is successful the option will assist in protecting from the depreciation in the foreign currency. The example for the use or the application of option hedging is when the small firms decides to bid or buy a land or property in another country then there is risk of the variation in the exchange rate therefore in this case hedging of the fluctuation in the exchange risk the buying of the call option is considered as the most suitable and favourable strategy for hedging (Khatta, 2008). Researcher Handlechner has emphasized on the option market can be best compared and evaluated with the insurance companies for example while purchasing or deciding to buy a car insurance it is required to pay premium. If the car is faced with an accident then the loss or the damage is compensated on the behalf of the insurance company but in case the car is not encountered with an accident then the value of the car increases or appreciates. The main reason the small companies prefer to adopt option strategy or technique for hedging of the exchange risk instead of adopting forward and future contract because the option generally has less flexibility and risk and possess or comprises of varieties of strategies that are available and the option is less expensive therefore it is more suitable for the smaller firms to adopt and implement. The strategy or the technique of swap is also applied or adopted by the small firms it can be defined as the strategy that is designed to determine the value of the contracts on the basis of the price of the assets that are underlined. The small firms also adopts the strategy of leading and lagging which determines the losses incurred and the profit or the gain that is generated by the firm and it also deals with the cash flow of the foreign currency and the sharing of the currency risk this is also considered as another important method or technique for avoiding the currency risk and the related transaction that is required to be shared between the parties. The small firm focuses on managing both the operational and financial risk that is related to the foreign exchange exposure (Handlechner, 2008). The small firm generally determines the production, operation, marketing and sourcing and the response of the firm towards the changes or the variation in the exchange rate that is related to the value of the firm. There are only few option contracts that is mainly used or applied by the company for paying off its price and the payoff. The financial hedging strategy option that is applied or preferred by the small firms serves as a tool for the contingent flow of cash. When a firm opts or decides for bid for the project that is carried out in the overseas market involves the risk that is related to foreign exchange. In case of the option market there is neither the daily variation nor change in the position nor the change in the initial margin since the position of option for hedging the exchange risk is marked to the market. Another reason for selecting or preferring the option technique by the smaller firms is the guarantee that it provides on the minimum flow of cash on the contingent claims. 4. Comparison of the similarities and differences of the use of the hedging techniques used by large and small firms The researcher Conrow has focused on the similarities for the use of the hedging technique by both and the large firms can be explained by the fact that both small and the large firms are subjected or are influenced by the variation or the change in the foreign exchange. The management of the exchange rate risk is considered as an important and vital part in the process of decision making and the exposure of the foreign currency. The strategies adopted for hedging the foreign currency risk reduces and eliminates the risk. Both the small firms and the large firms adopt the operational and financial hedging strategies for avoiding the exchange rate risk. The operational or the transaction exposure deals with the changes or the variations that is related to the changes on transactions and projects and the operating exposure deals with the discount rates and the cash flows that are expected in future. The common strategy that is adopted by both small and the large firms for managing the exposure of the risk related to foreign exchange is through the application of the complex financial derivatives. Hedging is considered as a strategy or technique for minimizing or reducing the unwanted risk that is related or associated with security. When a company or a firm hedges its exchange rate exposure by the application of the derivative then the company having more foreign subsidiaries will have large or more amount of derivatives (Conrow, 2003). Despite of several similarities, there are many differences in the use of the hedging technique by the small and the large firms. The large firms are more exposed to foreign exchange risk as compared to the small firms or the companies on the basis of the fact or in consideration that large firms are more exposed to foreign operations as compared to the operations of the small firms. And it has been observed that hedging is more suitable, preferable and important for the small firms as compared to the large firms as smaller firms have the high level of expectation for the future growth and development. The authors Chance and Brooks have emphasized that the large multinational firms or the companies are able to derive or obtain much high level of economies of scale as compared to the small firms which decreases the cost related to the trading of the financial derivatives. The larger firms or the companies possess high leverage and low liquidity as compared to the small firms which suggests or indicates that the firm with high leverage and low liquidity generally has more incentive for hedging and are very much sensitive to the fluctuations in the exchange rate as compared to the small firms or the companies with high liquidity that are subjected to adverse volatility in cash (Chance and Brooks, 2009). In the study of Madhumathi, the researcher has focused on the firms that are required to minimize the probability of risk or financial distress by maintaining lower yield on dividend and liquid assets. The large firms enjoys the benefit of cost advantage which facilitates the firm or the company as compared to the small firms or the companies which facilitates the large firms to purchase or buy more contracts as compared to the small firms. The small firms are subjected to less foreign exchange risk as they have less foreign transactions or operations as compared to the large firms (Madhumathi, 2012). 5. Conclusion The above paper discusses about the four financial hedging techniques. Managing of risk has been the main objective of the paper. The value of the asset as well as the margin of profit can be facilitated through hedging techniques. Operational hedging as well as foreign currency loans is generally preferred by the large multinational companies. The arrangement of forward contract is made by the parties involved in the transaction process. The rate of exchange is determined between the same parties. Several disadvantages related to the hedging techniques have also been discussed above. The smaller firms prefer to adopt the hedging technique with the aim of increasing a higher degree. The buyer has the option to select the particular date on when he will like to sell or buy the currency. The options available to the buyer are available only in case of the time of bidding. The example of insurance companies is the best suited one when one needs to compare the option market. The next part of the paper talks about the similarities in the hedging techniques opted by the large and the small firms. The efficiently adopted strategies reduce the risk and in some cases even acts as the catalysts in eliminating the risk. References Chance, D.M. and Brooks, R.E., 2009. Introduction to derivatives and risk management. Cengage Learning: USA. Conrow, E.H., 2003. Effective risk management: Some keys to success. AIAA: America. Cowan, A., 2005. Risk analysis and evaluation. Global Professional Publishing: UK. Handlechner, M., 2008. Risk management. GRIN Verlag; Germany. Khatta, R.S., 2008. Risk management. Global India Publications: New Delhi. Madhumathi, R., 2012. Derivatives and risk management. Pearson Education India: India. Ruozi, R. and Ferrari, P., 2013. Liquidity risk management in banks: Economic and regulatory issues. Springer: Germany. Shapiro, S.A. and Glicksman, R.L., 2004. Risk regulation at risk: Restoring a pragmatic approach. Stanford University Press: USA. Read More