Hedging

Foreign currency transactions are those transactions whose terms are denominated in a currency other than the entity’s functional currency. Foreign currency or transactions risk is a risk that arises due to fluctuations of exchange rates. Hedging means controlling or reducing risk. Foreign exchange risk can be neutralized or hedged by a change in the asset and liability position in the foreign currency. Foreign currency hedging aims to reduce currency risk.

The following are the possible ways to control risk:

1.  Risk can be reduced by entering a money-market hedge. This means that borrowing or lending in the money market can offset the losses in a foreign currency.
2. Hedging can also be done by purchasing forward (or futures) exchange Contracts. The forward exchange contract is a commitment to buy or sell, at a specified future date, one currency for a specified amount of another currency (at a specified exchange rate). Forward contracts lock in a fixed exchange rate, for the receipts and payments. This rate is usually the market determined forward exchange rate. Such forward rates are equal to the expected spot rate on the future date. Forward contracts offer stability to the receipts and payments. Both parties (the receiver and the payer) know exactly how much needs to be payed or received. This limits the losses but also limits the extra profits that could have been made, in case the rate on the date of the transaction had been more favorable than the predetermined forward rate. Similarly, hedging can be done in commodity markets through futures trading.
3. Another hedging strategy is to invest in foreign currency options. A foreign currency option is a contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period of time. The advantage here is that in case the spot rate is more favorable than the rate specified in the contract, the company can abandon the option since it is not an obligation.
4.  Leading and lagging incomes and expenditures are an internal way of reducing risk and can be used when money market and forward-market hedges are not available. Under such circumstances, leading (accelerating) and lagging (decelerating) can be used to reduce risk. A trader can lead (pay in advance) or lag (pay late) his foreign currency payments, depending on whether he expects the foreign currency to appreciate or depreciate, in the near future. The idea is that foreign currency depreciation (home currency appreciation) translates into lower receipts and higher payments, respectively.

5. Another internal way to reduce currency risk is netting receipts and payments. Netting involves matching (or clubbing) the receipts and payments in a currency, so that any losses in receipts are compensated by the gains in payments and vice versa. The major advantage of netting is that the costs associated with a large number of separate foreign exchange transactions are reduced.

           The best way of eliminating foreign currency risk is to not take it in the first place. Spot contracts are a way of hedging which can protect one from adverse exchange rate changes. In spot contracts, contract payments and receipts are settled on the same day. Massive exchange rate movements usually do not occur in such a small duration and thus the person is protected from foreign currency risks. This is an almost costless foreign currency hedging strategy.