This is a hedging strategy that is used for reducing risk in market of foreign exchange. It is also used in a hedging situation where one security is offset by another such as holding both short and long position for the same security during the same period of time. An investor holding diversified portfolio of bonds or global equities take short or long positions in their currencies in order to manage total portfolios risks. Investor of global equity who intends to reduce risks take short Australian dollar, Japanese yen, Canadian dollar and British pound but hold the Euro, the Swiss franc and US dollar in long positions. The currency position that will result will be high in value after fall in equity market. This strategy is useful for investments that last from one month to one year. (Jorion, 1993 pp56-57).
Analyzing Global Financing and Exchange Rate
From exposure to balance of payment, to interest rate risk and foreign exchange to futures and credit derivatives that are used to transfer and mitigate risks, there are there are derivatives for pricing which are complex and how they are applied in managing risks. The risks caused by foreign exchange originate from exchange rate and interest rate being volatile and other factors which are interrelated for individual companies. To be able to hedge and offer protection to changes in interest rate and currency, multinational corporations take steps to mitigate the risks.
Global financial and exchange rate risks offer treatment for foreign currency, price and management practices for risks in interest rate of multinational corporations in global economy which is dynamic. It gives out advantages and disadvantages of different hedging instruments and analysis of costs and benefits of other hedging vehicles. In order to manage global financial and exchange rate risks, swaps, futures and options are used. (Cohen, 2003 pp14-16)
Describing how it is used in Global Financing Operations
In global financial operations, a hedge is investment taken to reduce risk in investment. Hedging minimizes exposure to risks which are unwanted in a business while allowing the business to make profit from the investment. A hedger invests in security which underpriced in relation to the fair value and combines it with short sale of securities which are related. The hedger is in market movements and his interest is in performance of security which is underpriced relative to hedge.
Some risks are natural to businesses which are specific such as risk of increase or decrease in oil prices which are very natural to firms that drill and refine the oil. Other risks are unwanted and are not avoided until they are hedged. For example, a shopkeeper expects to have natural risks like competition and unpopular products. The risk of his products being exposed to fire is not wanted and is hedged through contract of fire insurance. All hedges are not financial instruments, a producer who exports his goods to another country hedge currency risk when making sales through linking expenses to currency which is desired. Banks and financial institutions hedge to control mismatches of asset liability such as matching maturity between long, loans at fixed rate and deposits on short term basis. (Gastineau, 1995 pp27-34)
It’s Importance in Managing Risks
The importance of currency value is in relationship with world markets and how it interacts with investment, monetary practices and international trade. If a currency is viewed in isolation, it appears to be abstraction even if it has significant influence in commercial relations as mechanism of pricing that affect international transactions. The impact of fluctuations in exchange rate on domestic aggregates affect economic activity where there is a sense of urgency to deal with markets which are volatile.
If currencies continue to be the medium of exchange in carrying out commercial transactions, fluctuations in market for relative currency will still attract attention of the banker, the investor, the exporter and the speculator. Transaction approach of exposure to exchange rate is very prominent. It has translation of currency that measure operating performance and divert attention of hedging techniques. Managers who are clever generate more cash gains from hedging currency without increasing output of business units.
When currency hedging is implemented properly, it is a management tool for foreign currency which is very valuable but if it is not implemented and supervised properly, it can turn out to be catastrophic. When implementing hedging strategy for foreign currency, it’s trading and hedging is a science which is imperfect. Currency hedging is associated with cost and a learning curve. Retail foreign exchange trader who needs trading and hedging advice should have a broker who understands the investment and is able to give non-biased advice. (Jorion, 1993 pp51-55)
Cohen B. (2003): Global finance and exchange rate: Chicago Press, pp 14-16.
Gastineau G. (1995): the currency hedging decision: CFA Institute, pp 27-34.
Jorion P. (1993): currency hedging for international portfolio: JSTOR, PP 51-57.