Exchange rate hedging is a method that companies and organizations use to eliminate risks of foreign exchange that result from transactions in foreign currencies. This elimination is the hedging in this case. The fundamental principle of rate hedging is to ensure the exchange of currency during a favorable exchange rate. Having exchanged favorable rates, investment with the native currency commences.
The rationale behind rate hedging is to prevent an investor from currency fluctuations in terms of the exchange rates. This safeguards him from potential monetary losses. It prevents the possible effects of wayward exchange rate fluctuations from negatively impacting on the income and expenditures. A trader who stays long on a given currency safeguards the downside exposure through hedging it with an offsetting short position in a different market.
Currency Risk Management Strategies Available For Australian Businesses
Australian businesses can adopt several strategies to manage currency risks and potentially prevent the effects of such risks. These strategies are both internal and external:
Internal Strategies
One of the internal strategies that Australian businesses can use to manage currency risk is the adoption of leading and lagging of income and expenditure. In this strategy, the businesses can lead by paying in advance or lag by paying late the foreign currency payments. This is on the basis of the businesses anticipation of the depreciation or appreciation of the currency in the foreseeable future. Foreign currency depreciation leads to the home currency appreciation. This often translates into lower receipts and higher payments.
Another internal strategy that these businesses can use is netting of the payments and receipts. This idea involves matching the payments and receipts in a currency. The aim of netting is to compensate the possible losses in receipts by gains in payment. It also compensates the losses in payment by gains in receipts
There are many other internal strategies that Australian businesses can use to manage the currency related risks. However, these are very efficient. Many businesses have used them, and they deliver good results.
External strategies
There are many external strategies that Australian businesses can use to manage currency related risks. One of these instrumental strategies is the forwards contracts. It is a very popular means of managing the risks related to currency in the financial field. They are contracts that lock fixed exchange rates for both payments and receipts. In many instances, the rate is forward exchange rate determined for the market. Forward contracts ensure stability in terms of receipts and payments. The payer and receiver know how much ought to be received or paid. They also have the knowledge of the ongoing rates of exchange. As a result, the transaction date does not matter here. This strategy limits potential losses as much as it limits extra profits. This happens in case the rates of exchange were more favorable than they are at the time of the transaction.
Another significant and popular external strategy that manages the currency associated risks is the currency swaps. Currency swaps refer to exchange transactions that happen in real time. In other words, the exchange of one commodity to another is made immediately. There is no delay since the exchange rates may fluctuate. Australian businesses can adopt this strategy to help in rate hedging and manage the risks associated with the currency. In this transaction, the payments and principal in one currency are swapped with payments and principal in another currency. The swapping appears difficult, but it is not. It is possible. It can be done since many businesses have used it before. It has great potential to reduce two foreign currencies by seeking intervention from another currency.
The foreign currency risk management is also through analyzing the foreign currency options. The Australian businesses should analyze the available foreign currency options keenly. These options derive significant value from their representative instruments. The basis of currency options is the valuation of currencies. Analyzing the options will bestow upon the Australian businesses the right to sell or purchase a specified foreign currency. However, it does not give them the obligation to do so. The implication is that it gives them the freedom of choosing which currency to sell or purchase on the basis of the currency valuation. The options will safeguard the interests of Australian businesses. If the currency rate is favorable, the businesses exercise the option. On the other hand, if the rate is unfavorable, they are under no obligation to exercise the option to sell or purchase.
The businesses should also focus on interest rate options. This will give them the right to purchase or buy a given rate of interest or sell such a rate. Like the foreign currency option, the businesses are under no obligation to purchase or sell in a given rate of interest. Both parties in the transaction know the potential receipts and payments. It will cover the businesses against interest rate fluctuations. This method is suitable when involving large foreign banks. Interest rate swaps can also do the trick and help in managing the risks associated with foreign exchange. Like currency swaps, interest rate swap contracts give two parties a chance of swapping a specific interest rate exposure with another.
Another good way of managing foreign currency risks is the use of spot contracts. It safeguards against the foreign currency risks by declining the contract on the first place or taking it on the spot. This protects against adverse exchange rates or interest rates by going for on spot contracts. In these contracts, payments are made almost immediately. As a result, it safeguards from possible price fluctuations. This strategy is good because it is less expensive and very simple indeed. Australian businesses can consider adopting it to survive against the risks associated with foreign currencies.
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