Currency hedging involves deliberately taking on a new risk that offsets an existing one, thereby reducing a businesses’ exposure to negative change in exchange rates, interest rates, or commodity pricing (Economists. Com, n. D. ). “Currency hedging allows a business owner to greatly reduce or eliminate the uncertainties attached to any foreign-currency transaction” (Fraser, 2001). It is impossible to predict the how much currency will be worth on the exact day that a company will be converting it.
With hedging, the uncertainly is gone. Many companies that have international operations are constantly Juggling multiple transactions, with payments that are staggered and tied to the swing off number of currencies. There are a growing number of banks as well as business to business websites that offer currency hedging, regardless of company size. It used to be that the only way to truly avoid the risk of currency fluctuation was to transact all international business in U. S. Dollars. For small impasses, especially, it would be hard to insist on these terms (Economists. Com, n. D. ).
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There are a number of currency hedges, including: spot contract; forward transactions; options; currency swaps; and non-deliverable forwards (Wichita, n. D. ). Spot contracts are a way of converting currency from another country into U. S. Dollars or for making a payment in foreign currency. Currency can be bought at today’s exchange rate, and in most cases, the final settlement occurs in two days. Forward transactions are very popular, especially for those Just getting into currency edging. Forward transactions allow a company to buy or sell a currency at a fixed rate at a specified future date.
This essentially locks in the exchange rate that an organization wishes to use, and eliminates risk (Wichita, n. D. ). “Options are contracts that guarantee, for a fee, a worst-case exchange rate for the future purchase of one currency for another” (Wichita). Options are different from foreign contracts in that the buyer is not obligated to deliver the currency on the settlement date unless the option is exercised. Currency swaps are a way for companies with securing cash flows in a foreign currency, or a company that is seeking financial backing in a foreign country.
Lastly, in a market where forward market does not exist or is restricted, although like a forward transaction, a non-deliverable forward makes it possible to hedge future currency exposure (Wichita). It should be noted that this type of hedge is settled in U. S. Dollars. The text cites the case of Japan Airlines CAL), which is one of the world’s largest airlines and a huge customer of Boeing (Hill, 2003, p. 307). Boeing aircraft are priced in U. S. Dollars, and those ordering normally pay a 0% deposit. When GAL. purchases aircraft from Boeing, it must change its yen into dollars.
The length of time between ordering the aircraft and taking delivery can be up to five years, and the value of the yen can change in that time period. When placing the order, GAL. has no way of knowing what the value of the yen will be against the U. S. Dollar in five years, therefore, one way of mitigating this risk was to enter into a forward exchange contract (Hill). GAL. entered into a ten-year agreement worth approximately $3. 6 billion that gave GAL. the ability to buy U. S. Dollars from a insertion of foreign exchange traders at various points during the next ten years (Hill, p. 07). Unfortunately, GAL. lost significant funds when the yen exchange rate surged during the time of the agreement, to the tune of $450 million, or as stated in yen, $45 billion. Over the entire life of the agreement, it is estimated that GAL. lost in yen, some $1 55 billion (Hill, p. 308) It is not unusual for international businesses to suffer losses because of unpredicted movements in exchange rates. The GAL. example above is more of an extreme case; however, it illustrates the risks company face in he foreign exchange market.
Some of these risks can be insured by utilizing the hedging tools described previously. Hedging is something that shouldn’t be entered into lightly, or quickly, especially for smaller, less established companies without a great deal of clout. To handle even simple forward contracts, an organization must have a high quality finance officer. Many organizations turn these types of transactions over to their lenders due to the need for expertise in this area (Fraser, 2001). Transaction fees must also be considered in the hedging process.
These fees re often embedded with in the conversion terms, and vary depending on factors. One is the clout of the organization and the other, the length of the contract. Generally, the longer the contract, the higher the fees will be (Fraser, 2001). Ideally, all international business transactions would be paid in U. S. Dollars and there would be no need for currency hedging. Unfortunately, many customers and suppliers will not go along with those terms. Businesses that hope to successfully operate internationally will do well to fully educate themselves relative to the benefits that renounce hedging offers.