Executive Summary
The availability of different methods of hedging against currency risks provides companies with the flexibility of choosing the ones that meet their needs best. The most common methods in the global hedging business include Euro bank account, currency forward contract, futures contract, currency options. The availability of several hedging methods provides multinational companies with ways of shielding themselves from currency losses.
Companies would therefore be in a position to choose methods that meet best their needs. In addition, more hedging methods mean that multinationals can choose between methods to use depending on current needs. Fact that all these hedging methods can be accessed from all over the world means that companies can easily access these services from all their worldwide branches. The greater number of hedging services should, however, not fool management that all of them would lead to successful protection against foreign currency risk. Instead, these hedging methods should be takes as risky ventures to be approached with utmost caution lest management exposes their companies to greater losses than the ones whose protection is being sought through these methods.
Introduction
International business opportunities expose multinational companies to foreign currency risks that could result in imminent losses when not well handled. One way of handling these risks is through currency hedging options that would be discussed in concurrent sections of this analysis. The four options discussed herein are the most common among international players, the reason being their wider availability and success in achieving desired goals. The four options include:
- Euro bank accounts, which involves opening bank accounts that are denominated by the foreign currency being hedged;
- currency forward contract that deals with the exchange of currency between two players holding different currencies;
- forward contract that involves players arranging to sell their foreign currency at certain prices on given dates; and currency options that provide players with rights to purchase certain currencies at certain pierces on given dates.
The latter two can trade through organized markets worldwide.
Euro Bank Account
This refers to opening a bank account that would be denominated in foreign currency that a company deals with mostly. Most companies prefer to open Euro accounts because of the currency’s stability and fact that it is the second most used currency after the Dollar. This makes it more attractive to individuals and companies to use it. In addition, many multinational banks provide this facility compared to accounts denominated in other countries’ currencies. Having the facility more readily available to many companies has led to increasing popularity among many multinational players. There are several advantages and disadvantages of using the system for the participating companies, some of which will be discussed in the section that follows:
Advantages
Euro bank accounts help participating companies lock in current exchange rates (Johnson 125), meaning that future currency swaps would be done using the current rates. in this regard, c companies get shielded from fluctuations that could take place during the time of the contract. Participating companies thus go on with their daily activities without worry that their profitability would be affected by the prevailing currency prices.
In addition, companies get shielded from any local or international event that could cause currency fluctuation in the international market. The second benefit comes from the fact that the cost of the contract stays the same during the contract’s duration (Allaynnis & Weston 274). his means that participating companies would not have to face extra charges during the contract term. Third, the duration of the contract could be extended beyond the originally agreed duration, which helps client companies to extend their protection.
In this case, companies are able to shield themselves from long-term exposure to currency risks such as unexpected fluctuations. Fourth, by opening Euro accounts, companies can hedge the exact amount of money that would be under transaction on a specific date in the future. This requires companies to understand well the amount of money that would be coming into the company on a specific date in the future. Failure to estimate the amount of cash inflow could lead to a situation where participating hedge lesser amounts than what is needed, which could lead to currency losses in the future.
In addition, having a Euro bank account enables companies to change the amount that had been hedged. This requires senior management to be fully briefed on the number of funds that could be flowing into company coffers in the near future. Being provided with the ability to change the amount hedged is of great advantage to client companies because they use the originally agreed exchange rate. In this case, companies can reduce the amount hedge should it appear that currency loss would be made during the maturity date. Equally, companies can increase the amount hedged in case it appears that gains would be made.
Disadvantages
One of the major disadvantages of using Euro bank accounts to hedge against foreign currency is that companies have to deposit large amounts of cash into these accounts. This means that companies facing hard financial times or those with tight budgets get locked out of the system, the reason being scarce financial resources.
Sometimes companies could use the funds in some projects that would end up bringing more cash than savings to be made in the system. n this case, senior management should consider weighing options of investing the money in some income-generating assets or buying into Euro bank accounts. his is a hard decision for the management to make because none can tell on the future of currency exchange rates in the international market, especially considering that Euro is a floating currency that is not subject to arbitrary central bank control. The second major demerit originates from the fact that companies using credit lines to fund their Euro bank accounts are subject to higher exchange rates in the United States (Simons 635).
This means that participating companies get exposed to the extra cost of increased interest payments in local financial institutions. This could result in companies falling to shield themselves from a risk that could lead to reductions in profitability. unfortunately, it is the small and medium-sized companies that lack enough resources to buy into Euro banks, which means they are the ones that could use credit resources. Exposing them to the increased cost of getting credit erodes the facility’s attractiveness. As a result, few among them would take advantage of the facility, failure of which expose them to currency fluctuations.
Currency losses that are made by these small companies mean that their growth gets curtailed, meaning that it would take them longer to achieve their goals. his scenario is worsened by the increased participation of companies in the international market. Fact that it is through the increased participation in the international market that enables small companies to grow into big operations. On their part, management in growing companies should understand that the benefits of participating in the international market have to be accompanied by measures of protecting accruing revenue from currency shocks.
Currency Forward Contract
Currency forward contracts refer to situations where two entities enter into the agreement of exchanging currency at a particular date and rates (Simons 625). Both sources are therefore obligated to meet their part of the agreement. multinational companies participating in international trade could therefore enter into agreements with other parties. One way of doing this is by communicating with international enter[prises that would like to hedge with the dollar. In this case, multinational companies would agree to exchange their foreign currency with dollars at a particular date in the future.
Equally, the corresponding side would agree to exchange their dollars with the foreign currency currently held by the participating multinational company. The trade would leave both companies well off considering that they both entered into the agreement as equal partners. This method has several advantages and disadvantages, some of which are discussed below:
Advantages
This system is said to be flexible because it is mutually agreed between two equal parties. The clause of equality enables participants to negotiate in ways that would serve their best interests. Participating companies are therefore able to look for partners that are looking for what is being offered. Indeed, the system resembles the old barter system of trading, where the seller goes looking for buyers that would be interested in the exchange. In the forward contract agreement, multinational firms would be seeking players in the global market that would be needing the amount of foreign currency being offered and at the agreed date.
Having both parties match their needs leads to greater satisfaction. This leads to another benefit that players, even the small ones, can get other companies to do perform the forward contract option. As a result, small businesses, described above as least favored by Euro bank accounts, are provided with the ability to get parties to jointly participate in the forward contract contracts. The other benefit comes from the fact that participants are in a position to express their terms to the other parties. Fact that the contract is entered by two parties means that they can negotiate on exits periods, thus making it more flexible.
Disadvantages
Currency forward contracts suffer from the lack of central secondary markets (Johnson 320) that could help participants to manage the system. This means that the two parties are completely responsible for seeing that the agreement is completely followed. Senior management in the firms has to therefore follow all aspects of the contract, which require they stop working on other projects in respective companies. This could be regarded as deviating from the normal operations in the business, as senior management fails to embark on concentrating on currency risks. Secondly, companies participating in the system may fail to get the most competitive exchange rates.
This is caused by the participation of just two players. The possibility of more players being involved in the system is completely low. Third, companies participating in these contracts are faced with a lack of professional advice dealing with such matters. Fourth, middlemen helping the two parties in the contract charge some commission, some of which would go to even 5-10 percent of the total amount being hedged (Nobile 2005). In addition, the middlemen get remunerated for the entire period of the contract until the final exchange date. Another disadvantage of the system develops from fact that companies cannot cancel the contract without the other party’s approval, which could easily happen in organized markets.
This means that participants are completely locked in to the system, until the final day. Fifth, companies receiving huge amounts of money in their businesses are tasked with the hard task of engaging in many contracts in order to hedge against currency risk (Duffie & Ming 920). For instance, companies receiving monthly revenues in foreign currency are faced with the challenge of looking for contracts that would cater to this regular and increasing risk factor.
Futures Contract
The futures contracts are similar to the just mentioned currency forward contract, the only difference being that the former is performed in organized stock exchanges, which means that the participants do not know the other party. In this case, participating companies talk with their brokers or banks about hedging against currency risk. The companies provide information on the amount they want to hedge and the duration of the contract (start and end date). They then agree with agents on the amount of commission to be charged on the transaction—the rest is handled by the agents who go to the market in search of parties that would be willing to enter into the positions directed by clients. Benefits and costs of the system are described below:
Advantages
First, the availability of a secondary market enables participating companies to get out of the contracts at any time, as long as there are some buyers interested in taking positions. Since the secondary market for these positions works like regular stock markets, companies participating in futures can easily find individuals wanting to buy or sell currency positions. Fact that information technology has enabled people from all over the world to participate in futures markets located in other countries means that the pool of buyers and sellers has increased significantly. For instance, companies selling or buying positions in Chicago’s Mercantile Exchange or London’s International Financial Futures Exchange are assured of having their positions being taken by people from basically all over the world.
The greater number of players in both markets provide multinationals with competitive commissions that have been reported to be dropping fast from their highs of 5-10 percent to lower single digits (AIMA 2003).
This assurance is the greatest benefit that comes with this type of hedging. As a result, companies can choose to drop their position once their risk factor evaporates. In addition, the participating countries have the advantage of changing their positions at will. Fact that the market has many participants provide companies with the ability to change their positions as their risk factors change. Third, the organized exchanges take care of all aspects of the contracts, which leaves management of participating companies with time to concentrate on matters pertaining to long-run strategies. The organized exchanges also provide advisory services important to the individuals participating in the futures market.
Disadvantages
Despite the just-mentioned benefits of the system of the future, there also exist some disadvantages that participants have to consider before embarking on engaging in the contracts. First, participating companies face the challenge of being dictated on the terms of the contract. This is unlike in some of the options, where participants have the advantage of negotiating terms on themselves. Second, Fact that participants use the services of brokers means that commissions have to be paid during the beginning of contracts and the end. In some instances, companies have to pay brokers as custodians, a fact that increases the costs of running the contracts. Third, the futures contract is a speculative affair means that companies get exposed to other market factors.
This especially happens because the market is prone to the whims of other market participants. In addition, national and global events could lead to changes in currency exchange rates that could lead to participants getting exposed to speculative affairs making positions taken previously less attractive. This additional demerit may end up exposing participating companies to more risks than hamper company performance. Though the option relieves management from the burden of following daily movements in the company positions, senior management should consider balancing these challenges with the good that comes from the contracts.
Currency Options
This option is usually undertaken through a financial system and provides participants with the right to purchase certain currencies at a given price over a given period of time (Nobile 2005). The participants have the option of exercising their right to undertake the transaction but are not obligated on undertaking them. The several considerations that go in the prices of determining the level of the exchange rate that would be used in the contract include the current exchange rate for the currencies in question, interest differentials in the economies whose currencies are being used, the commission to be charged by the intermediaries, and the historical volatility in the currencies being used (Duffie & Ming 920).
Among multinational companies that have taken this route include BMW that has hedged against all major currencies through 2009 (FX Street 2008). Posch, too, has been hedging against currency risk, which has resulted in better protection of its global earnings. However, motor companies such as Volkswagen that have not been hedging against currency risk have seen revenues being eroded through exchange rate losses.
Advantages
Like the futures contract, this one, too, can be traded in organized markets that can be accessed by people world. In addition, more trading on the option can be done on the interesting, which increased the probability of having many people take place, much to the benefit of companies that are in need of taking positions regarding their currency risks. This benefit further means that participants are graced with a liquid market that allows them the flexibility of choosing participants that whose interests mirror those of forms interested in trading. Second, the availability of a ready market for this option lead to participants being provided with the flexibility of dropping options when it is seen that company risk factors are changing. This means that participating firms can change their options at any given time.
Disadvantages
Services provided by middlemen in the organized stock exchanges attract commissions, meaning that the cost of participating in the exchange is greater compared to that of some of the options explained above. This means that the participating firms have no choice other than to uphold the contractual agreements. In addition, the participating firms are robed of the flexibility of extending contract periods. Unlike in the Euro band and future contracts that allow participants to extend the lives of current contracts, participants in this option have to terminate it completely and then embark on starting afresh. Second, participants have to pay risk premiums to the middlemen, which adds to the cost of hedging considering that they have to pay hefty commissions.
Most Preferred Instrument
The Euro Bank Account is the most attractive option for a multinational company willing to take a position against foreign currency risks. First, the Euro bank provides companies with the flexibility of exiting the option at earlier stages stipulated in the agreements. A multinational company can elect to get out of the contract should it appear that currency risks have disappeared on their own, or the company has developed other measures to deal with the problem (Abo & Simkins 2005).
Secondly, the option allows companies to extend the period of the contract. This means that companies can hedge against risks that would lead to protecting companies against risks that could develop in the near future. Most other options do not provide this flexibility. Third, participants in this program can hedge against an exact amount of money that would be under transactions in the maturity date. In this regard, companies can easily manage their finances in the best way possible.
All other options do not provide the flexibility for hedging against a certain amount of funds. Third, companies participating in this option have the benefit of changing the number of funds to be hedged. This could be done by increasing or decreasing the figures being hedged. This is good flexibility for companies that have to deal with the constant flow of foreign currency. For instance, a multinational company receiving monthly or quarterly revenue denominated in foreign currency can keep depositing it into the Euro bank until the maturity date of the contract.
Conclusion
The different hedging options mentioned above provide flexibility for different types of businesses faced with the need to hedge against currency risk. The paper has established several differences in the options to an extent that the most proffered one has been pointed out. However, it is totally upon participants in the market to investigate the option that serves their interests best. The availability of organized markets is an advantage to players who get relieved from the cost of looking for partners to involve in hedging activities. Senior management willing to protect their companies from currency risk should consider hedging methods as risky procedures (AIMA 2003).
Having that thought would lead to a thorough investigation of methods that best meet organizational needs. The management should also ensure following on market trends on the several methods of hedging that can be used in hedging against foreign currency risk. This is a matter that should be investigated before during and after choosing the most preferred method, the reason being that information regarding currency hedging is important in the day-to-day running of organizational activities.
Such information can easily be accessed over the Internet as well as from middlemen used as hedging custodians. Any failure to be well aware of recent trends in hedging practices could lead to companies exposing themselves to risks works that are the ones being addressed through the aforementioned methods. Companies have to also consider that correct prediction of future earnings is the first step to ensuring successful hedging. Getting future cash flow right, therefore, aids in successful hedging.
References
Abo & Simkins, 2005, Investigating Relationship Between Currency Hedging and Real Options, Financial and Economics Review, 14, 352-370.
AIMA, 2003, Financial Risk in Currency Hedging. AIMA Journal, 2-12.
Allaynnis, G & Weston, J., 2001, Investigating Foreign Currency Derivatives, Oxford Finance Journal, 14, 241-275.
Duffie, D. & Ming, H. 1996, Swap Rates and Credit Quality, Finance, 51, 919-958.
FX Street 2008, BMW Starts Hedging. Web.
Johnson H., 1999, Global Financial Institution and Market, Boston, Blackwell.
Nobile, J., 2005. Currency Hedging Vehicles. Web.
Simons, D., 2001. Currency Swap, Political Economy Journal, 110, 608-665.