Foreign Exchange Risk Essay
A currency swap involves two parties that exchange the principal and interest payable on it with one another in order to gain exposure to a desired currency (Tewari, 2013). If a US-based company wants to fund its Chinese operations and a Chinese company wants to fund its US operations then these two companies can take out a loan from their own countries and swap them. Both companies can protect from the fluctuation of exchange rate since they swap the loan back at a fixed exchange rate on the maturity date. As a result, the swap will insure companies against exchange rate volatility.
Besides using forward contracts and currency swap, companies use natural hedges to minimize their foreign exchange risk. A natural hedge is a type of hedge that does not require the use of sophisticated financial instruments to reduce the foreign exchange risk. One example of natural hedge is companies try to match revenues with expenditures in the same currency. In other words, companies require their customers to pay them in the same currency as their expenditures. Moreover, companies can build their manufacturing plant in the foreign country so that production costs are in the same currency as …show more content…
The fluctuation in the currency rate of Japanese yen could affect Toyota’s operations and its financial statement. The change also could affect Toyota’s pricing of products sold and materials purchased in foreign currencies. Besides producing its cars in the United States, Toyota employed the use of currency swaps to reduce currency risk. With currency swaps, Toyota was able to lock in a fixed exchange rate when it swapped the principal amount of the loan back on the maturity date.
Instead of applying currency swaps, Tohoku Electric Power Company (TEP) chose to use forward contracts to hedge against yen risk. TEP used thermal power to generate electricity (Iajima, 2013). The cost of imported natural gas increased drastically due to the weaker yen. However, TEP could not pass the higher costs to consumers. As a result, TEP utilized forward contracts to hedge against a weaker yen (Iajima, 2013).
It is imperative to hedge against currency risk since companies’ profit can dissipate quickly due to the fluctuation of exchange rate. In some instances, companies may suffer a major loss regardless of an increase in sales. A hedge is a way to safeguard against currency risk. Forward contracts, currency swaps and natural hedges are some of the ways to lower currency risk. Airbus, Toyota and TEP were capable of applying these hedging strategies to protect their companies from substantial