This paper will explore the different ways by which business entities can deal with the exchange rate variations to protect the value of their assets and profits against unpredictable risks.
In recent years derivatives have been developed in order to provide some sort of insurance in the face of uncertainty caused by the changes in the foreign exchange rates. Derivative, or hybrid, investments, unlike stocks and bonds, do not represent ownership of shares, such as stocks, or a promise of loan repayment, such as bonds, and are once or twice removed from a real product. For example, a crude oil futures contract is a bet on which way crude oil prices will move, but what happens to the product itself is of no interest to the investor
When an individual converts one currency into another in an actual exchange, the risk inherent in this activity is called a transaction exposure. Multinationals often face translation exposure, or the risk that arises from the need to re-state one currency in terms of another currency for accounting purposes. The risk arises because exchange risk volatility can impact the value of net assets and profits at the time of their translation. (See Kolb 1997).
Financial derivatives are based on an underlying instrument such interest as debt instruments or foreign currencies. Most predominant among these derivatives are forward contracts, but futures contracts, option contracts, and swap contracts are also used by businesses as means of hedging. Hedging is distinguished from speculation in that the hedger wants to shift risk to others while the speculator hopes to make profits for the risk he is taking.
A futures contract is an agreement that one party will accept delivery of a particular asset – either real or financial – on some date in the future at a price determined today. If one is intending to buy an asset in the future, one could buy a futures contract (a long position) today to fix the