Currency Hedging in Global Business

Although they have the potential to make the investor a strong profit, foreign investments can also present many risks. Currency hedging, which is a technique or techniques used to minimize risk in exchange rates and currency values, is a way to allow the investor a better opportunity to profit from the investment.

Buyers and sellers have multiple currency hedging options, and each optionhas its risks and its benefits. Each option benefits global financing operations in its own way by adding stability to currency exchange. This paper will examine some of the different types of currency hedging, how they are used in global finance operations, and how they are used to minimize risk.

Currency Hedging in Global Business

The first currency hedging option to be examined is the Spot Contracts option. "Spot foreign exchange contracts provide the most immediate conversion of one currency to another. For most countries, payment typically would be achieved within two business days. Spot contracts are useful in handling payables or receivables involving a foreign currency..." (2002)

Spot contracts can be a form of currency hedging used to minimize risk in foreign investments and return, although they are not the best option and can often be the reason other hedging vehicles are used.

With a spot contract, the investor signs a contract stating he or she will trade at the foreign currency exchange rate but must settle within a two day period. The short timeframe of settlement does not allow for much time and is, therefore, normally not used on its own and can, in fact, create even more risk to the investor. (Noble, 2008)

Potentially, a better option for investors is a Forwards contract, which is a contract that locks in a currency exchange rate for future sale. (Noble, 2008) Where exchange rates fluctuate daily, a forwards contract avoids this fluctuation by offering a rate guarantee.

Forwards contracts can minimize risk if the rate is higher on the date to be sold, but it can also increase risk if the rate is lower. Forwards contracts can be a gamble, which makes itimportant for the purchaser of the currency to have a good understanding of economic ups and downs in order to make an informed decision.

Futures contracts, although similar to forwards contracts, are different because they are more standardized than forwards contracts. "...futures contracts have standard contract sizes, time periods, settlement procedures and are traded on regulated exchanges throughout the world." (Noble, 2008) This type of hedging offers stability with regulation but is also an obligation and not an option.

The Interest Rate Option of currency hedging allows the buyer the right to buy or sell an interest rate contract at a specific price on or before the expiration date of the contract. (Noble, 2008) When the buyer does not know what the interest rate might be at a specific time, this could be a cost savings if the rate increases. "Interest rate Options are European-style, cash-settled options on the yield of U.S. Treasury securities." (CBOE, n.d.) There isno obligation to the buy at this rate, so the risk is minimal. The benefit allows protection against any interest rate rise or fall.

Conclusion

Interest rate swaps are a form of currency hedging that could be advantageous in global financing operations, as it allows companies to minimize risk by swapping interest rate exposure. (Noble, 2008). For example, the buyer and seller will enter in to a contract where a fixed interest rate is swapped for a floating interest rate or vice versa. Interest rate swaps canalso offer float to float swaps and fixed to fixed swaps.

When US companies enter in to agreements to finance global operations, several types of risks are presented, and currency hedging allows for options to minimize those risks. Examined in this paper were a variety offorms of currency hedging, all used to minimize the risk of global financing in regard toexchange rates and value of currencies. The hedging techniques examined were: spot contracts, forwards contracts, futures contracts, interest rate options and interest rate swaps. Each hedging option has advantages and disadvantages, depending on the situation it would be used in. The key is assessing each option and understanding each well enough to know which to choose.

References

(n.d.) Interest Rate Options, CBOE Chicago Board Options Exchange

Retrieved on June 15, 2008 from http://www.cboe.com/Products/InterestRateOptionsSpecs.aspx

(2002) Spot Contracts, California Bank and Trust. Retrieved on June 15, 2008

from http://www.calbanktrust.com/Products/products/ibg/html/ibg_spot.htm

Noble, J., (2008) Types of Foreign Currency Hedging Vehicles in Ezine Articles

Retrieved on June 15, 2008 from http://ezinearticles.com/?Types-of-Foreign-Currency-Hedging-Vehicles&id=33053