Hedging - Essay Example

Topic: Hedging XXXXXXXXXX XXXXXXXX XXXXXXX XXXXXX XXXXXXXXXX Hedging is an activity that allows firms to minimize risks resulting from changes in rates of exchange in the foreign exchange market. These firms mostly operate internationally, meaning that they have affiliate firms in more than country. Variations in the exchange rate pose risks to these firms in the context of operations and sales (Albuquerque, 2007, pg. 17). VirtualBooks Company in the UK is affiliated to another firm in Slovakia.

Readers are to be imported for sale in the UK, a situation which puts the UK firm to a risk, owing to the exchange rate characteristic to the different currencies involved in the transaction. Variations in the exchange rate between the Euro and the Sterling Pound may cause the UK firm losses or profits based on the adopted hedging strategy. Based on the chart provided, hedging instruments will be assessed in relation to each currency, and the best hedging strategy for the UK firm determined.

Forwards A forward is a contract or an agreement that involves foreign exchange rates, where the parties bound to the agreement are obliged to buy or sell a specified foreign currency amount at a given time in future (Muller, 2006, pg. 195). However, the exchange rate is fixed in the current time based on the current exchange rate. The provided chart denotes the variations in the exchange rate of the two currencies involved; the Euro and the Sterling Pound. The chart represents increases and decreases in the amount of Euros required to purchase one Sterling Pound.

The general implication of the chart is that the Euro is averagely cheap compared to the sterling Pound. The Slovak affiliate firm is expected to export readers for sale in the UK. The importation of readers into UK from Slovakia is favourable given the exchange rate trend on the chart. The UK based firm is therefore due to make profits from the sale. However, the exchange rates movement is uncertain. In this regard, the Slovak affiliate may enter into a forward contract, where the counterpart will buy the Sterling Pounds paid by the UK firm.

The Slovak firm gets its due Euros prior to the agreed exchange rate, thus minimizing the loss that would have otherwise resulted from exchange rate fluctuations. Futures This is another form of a forward contract. In this case however, the exchange trade is standardized and strictly based on specific times of maturity. Futures only mature at specific times denoted by one, three, six, nine and twelve months or in three years (Muller, 2006, pg. 210). Both the UK and the Slovak affiliate firms may experience difficulties in matching the maturity periods if they choose this hedging strategy.

The exact amounts of foreign currency in the context of the underlying risk exposure may be difficult to determine. In this case, using futures as a hedging strategy is not advisable. Options This hedging strategy offers a choice in exercising the agreement that binds the parties to the option. The buyer or the seller may choose to exercise the option or fail to (Capstaff, 2007, pg. 117). The Slovak firm may buy an option to sell Sterling Pounds when the payment is done by the UK firm after it imports the readers.

The strike price is an important factor that will determine the Slovak firm will exercise the option or not. A strike price higher than the Euro at the maturity time of the option will make the Slovak firm exercise the option and vice versa. When the strike price is low, the firm will consider not exercising the option, thereby selling the Sterling Pounds in the foreign exchange market. Such would be the case in the UK when the firm is importing. The fundamental issue here is to maximize business welfare by reducing the risks accrued from exchange rate variations.

The flexibility associated with the options in relation to the currency flow provided in the chart makes options the best hedging instrument for the company. References Albuquerque, R. (2007): Optimal Currency Hedging, in: Global Finance Journal, 18(1), 16-33. Capstaff, J., A. Marshall and J. Hutton (2007): The Introduction of the Euro and Derivative Use in French Firms, in: Journal of International Financial Management and, 18(1), 117. Muller, A. and W. Verschoor (2006): European Foreign Exchange Risk Exposure, in: European Financial Management, 12(2), 195-220.