Foreign Exchange Risk Case Study

841 Words 4 Pages
As business becomes more globalized and trade continues to expand internationally, companies need to understand and reduce the risk associated with international business. Though there are many risks faced by companies when operating internationally, including political, financial, and cultural, this paper will specifically discuss the financial risk associated with exchange rates and how companies mitigate this risk through currency hedging.
Foreign Exchange Risks
Foreign exchange risk is “the risk that a business’s financial performance or position will be affected by fluctuations in the exchange rates between currencies”, and because foreign exchange rates fluctuations do not always act favorably, these fluctuations can have a negative
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A company purchasing a forward contract is guaranteed the exchange rate agreed upon in the contract regardless of the market exchange rate. Therefore, the expected cost will not be affected if the domestic currency weakens, foreign currency strengthens, or both, resulting in an unfavorable fluctuation. However, companies are also not able to benefit if the domestic currency strengthens, foreign currency weakens, or both resulting in a favorable fluctuation. The cost for a company to hedge foreign currencies with forward contracts is approximately equal to the difference between domestic interest rates and foreign interest rates in the particular country over the contract period (Tweedy, Browne Fund Inc., 2014).
Futures contracts are similar to forward contracts in that the contract is based upon an agreement to buy or sell at a given quantity at a certain point in the future for a predetermined amount. However, “futures contracts are normally traded on an exchange” and are standardized by the exchange (Hull, 2012, p. 7). Examples of exchanges on which futures contracts are exchanged are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) (Hull, 2012, p.
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Unlike forward contracts, this method of currency hedging “allows companies to benefit from favorable movements in exchange rates” (Export Development Canada, 2010). Though foreign currency options often have an upfront cost, this is the maximum possible cost to the company. If the foreign exchange rate fluctuation is unfavorable, the company can use the foreign currency option exchange rate at the cost of the premium. Alternatively, if the foreign exchange rate fluctuation is favorable, the company can forego the foreign currency option and benefit from the current foreign exchange

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