Overview of the hedging techniques:
In the financial market, almost all of companies need to face the currency risk. In order to manage the currency risk, companies will use different hedging techniques, such as financial and operational hedging techniques. For example, money market, futures contracts, options and forwards contracts are commonly used by firms, as well as operational hedging techniques. All of 4 types of financial hedging techniques are short-term hedge. Money market is a part of financial markets for assets involved in short-term borrowing,lending, buying and selling. Its features are high liquidity, lower risk, such as treasury bills. Futures contracts are ...view middle of the document...
Disadvantages: 1. More complex 2. Fixed future rate: lose chances to get the movements in exchange rate.
Futures contacts: advantages: 1. Lower commission 2. Higher leverage 3. Reversing positions easily 4. Higher liquidity.
Disadvantages: 1. Highly risky from leverage 2. Standardized products, fixed amounts and terms 3. Leading to over-trading by lower commission 4. Just a partial hedge(Finance Learners 2014).
Options: advantages:1.leverage 2. Risk/reward ratio: Allowing you to have limited downside but not a limited upside. 3. Unique strategies 4. Low capital requirement.
Disadvantages: 1. Lower liquidity 2. Higher spreads 3. Higher commission 4. Complicated: especially for the beginners. 5. Time decay 6. Less information: it is difficult to get some analyzed information. 7. Not available for all stocks(Thinktrade 2006).
Forwards contacts: advantages: 1. Providing a complete hedge 2. Offering a price protection 3. Easy to understand 4. Over-the-counter products.
Disadvantages: 1. Having a default risk 2. Difficult to cancel contracts 3. No intermediate cash flows before settlement 4. Hard to find a counter-party.
Market selection strategies: advantages: 1. Cash flow will be more stable 2. Reducing economic exposure rapidly. Operators need to find out the hedging technique which is suitable for their firms. Therefore, the virtue and drawback must be considered carefully.
Some examples of firms use different hedging techniques to manage currency risk.
|Derivatives used |Never |Occasionally |Frequently |
|A:transaction exposure |
|1.forward contracts |3 |3 |13 |
|2.futures contracts |15 |0 |1 |
|3.swaps |7 |5 |6 |
|4.OTC options |11 |4 |0 |
|5.exchange-traded options |15 |0 |0 |
|B:translation exposure |
|1.forward contracts |8 |5 |6 |
|2.futures contracts |14 |0 |0 |
|3.swaps |8 |4 |5 |
|4.OTC options |13 |1 ...