Firms Currency Hedging

Category: Accounting

Many firms attempt to manage the exposure and publicity of their native currency through hedging. Currency Hedging is used to an approach intended to deal with the severity of the risk that may occur when involved in a foreign investment tactic. Basically, the construction of a Currency Hedging method would attempt to reimburse any alterations or changes in the comparative value of the currency. The purpose of Currency Hedging schemes is that by minimizing the publicity of the investors to negative shifts in the foreign market, investors will still have a reasonable return on their investment even if the specific market sinks. Therefore, hedging is used to protect the owner of any existing asset from loss. However, it also eradicates any growth from an increase or boost in the value of the asset hedged against.

Generally, any hedging strategy is understood to assist in protecting the investor from events that could threaten or cause a deal to lose money. When it comes to currency hedging, the scheme is to convert or exchange the currency while the rate of exchange is positive, and then invest with the currency that is indigenous to the country of origin where the investment is taking place. For example, "rather than paying for shares of stock connected to a company based in the United Kingdom with United States dollars, the investor would first convert the dollars into British pounds, then use the pounds to make the actual stock purchase."[1]

Like any other wealth-building schemes, hedging encompasses both advantages and disadvantages. These benefits and drawbacks diverge with "trading style, investment preferences, market changes, other risk-minimizing practices and trading goals."[2] In brief, the benefits that a person gets from hedging his risks cannot exist for another trader.

There are a number of disadvantages of hedging, the first one is that hedging involves costs that can reduce or use up the profit. Secondly, Risk and reward are often related to one another; as a result, reducing risk will lead to the reduction and lessening of profit. Also, for most short-term or temporary merchants, such as "for a day traders", hedging is a complex strategy to pursue. Furthermore, if the market is performing well or moving efficiently, then hedging can offer little or no benefits. This is because managers cannot outguess or outwit the market. In addition, Trading of opportunities or expectations often require higher account necessities like more capital, higher investment or balance. Lastly, Hedging is a strict trading strategy, and for hedging to be successful it involves and calls for good trading skills and experience.

Moving on to the advantages of hedging, the first one is that hedging is a very good temporary risk minimizing strategy for long-term traders and investors. Secondly, Hedging tools can be used for securing profit and it allows traders to survive hard and tough periods in the market. In addition, when hedging is successful, it provides the trader with protection against "commodity price changes, inflation, currency exchange rate changes, interest rate changes, etc."[3] Also, hedging can also be considered as a time saver, as it is not mandatory for the constant trader to observe his portfolio as a consequence to the instability of the market. Finally, hedging provides the trader with the opportunity to practice complex decision trading strategies to maximize return.

Many firms use hedging to manage their currency exposures. Foreign Currency Exposure is "a measure of the potential for a firm's profitability, net cash flow, and market value to change because of a change in exchange rates."[4] There are three main types of Foreign Currency Exposure: transaction, operating, and translation.

Transaction Exposure is the risk faced by companies involved in international trade due to the change in the currency exchange rate due to the entrance of the companies to previous financial obligations. It occurs from the purchasing or selling of goods and services when the prices are given in a foreign currency. For example, "a U.S. firm sells merchandise on open account to a Belgian buyer for €1,800,000, payment to be made in 60 days. The current exchange rate is $1.1200/€. Seller expects to receive €1,800,000 × $1.1200/€ = $2,016,000 when payment is received."[5] Therefore, the transaction exposure arises because of the risk that the U.S. seller will receive something other than the $2,016,000 expected. Another example is the borrowing of subsidize when repayment is to be completed in a foreign currency. Other types of Exposure are Operational Exposure and Translation Exposure.

A great example for hedging against the risk of deteriorating profits due to the fluctuations in the foreign exchange rates is the case Lufthansa's purchase of Boeing 373s. According to the case, in January 1985, Lufthansa, Germany's national airline, is under the chairmanship of Heinz Rahnau, signed a contract with Boeing, a U.S. company, for the purchase of 20 Boeing 373 jets. Boeing agreed to convey the 20 aircrafts to Lufthansa's requirements in one year (January 1986). Lufthansa would have a single payment due of $500 million, given a spot exchange rate of DM3.2/$ in January 1985, this was an expected purchase of DM1.6 billion.

In the end of the case, Rahnau's expectations proved correct. The dollar did indeed fall in the coming year from DM3.2/$ to DM2.3/$ by January 1986. The total cost to Lufthansa for agreement of its compensation to Boeing totaled DM1.375 billion. The difference between the currencies is vast and too evident, and exchange rates are a crucial part of Currency Hedging and should be taken to consideration. In this case it is proven that currency hedging does not increase the firm's market value, this is due to the fluctuation of the currency rate.

A good example of a successful hedging method is Porsche. In January 2004, Porsche's management became concerned with re-evaluating its currency hedging strategy as it was becoming an attraction for criticism. After the re-evaluation the currency hedging results had been positive, and although that was the case, many experts believed that Porsche had been simply lucky rather than just being good.

Companies and investors seek security and safety for their activities. In foreign investments, these two parties encounter challenges due to the foreign currency exposure, fluctuating currency exchange rates. Currency Hedging is used to reduce these risks through processes, converting currencies to the native one, and sometimes agreements, agree on selling securities if there is a loss.

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