Negative Effects Of Foreign Exchange Risk

1246 Words 5 Pages
With the development of world, more and more companies begin to trade internationally. The reason is that there is large potential market which means there is large potential earning. However, international companies have to consider a factor that may have a significant negative effect on their earnings. That factor is foreign exchange risk. Foreign exchange risk is the changes in the exchange rate may make exporter receive less money, or make the importer pay more money than expected. In order to reduce the negative effects of foreign exchange risk, it’s very important for CFO to know how to hedge foreign exchange risk. Before knowing how to hedge foreign exchange risk, client needs to know how foreign exchange risk arises. Foreign exchange …show more content…
There are two common derivatives that used to hedge foreign exchange risk. The first one is foreign currency forward contract. Foreign currency forward contract is an obligation that company must purchase or sell foreign currency at a particular price in a future particular day. Spot rate and forward rate are really important concept here. The spot rate is the price at which a foreign currency can be purchased or sold today. In contrast, the forward rate is the price today at which foreign currency can be purchased or sold sometime in the future. (Doupnik, 2015, p. 343) To explain foreign exchange forward contract by using an example, company ABC enter into a foreign currency forward contract that require company ABC to pay $1.2 for 1 euro (forward rate) in 6 months from now. After 6 months, the spot rate on contract executed day is $1.4 for 1 euro. Because of forward contract, company ABC only need to pay $1.2 for 1 euro. That is how forward contract help company to avoid uncertain loss on foreign exchange fluctuation. The second derivative is foreign currency option. A foreign currency option gives its owner the right, but not the obligation, to buy or sell currency at a certain price (known as the strike price), either on or before a specific date. (Foreign Currency Option, n. d.) Company exercises option to sell the foreign currency is called put option; company …show more content…
Accounting to the scenario, 60% of revenue are constitutive of currencies A, B and C; these three currencies are fairly stable. So, I highly recommend this company to use foreign currency forward contract to hedge foreign exchange risk. The reason is companies can estimate stable currencies more accurately, forward contract will not make company have a significant gain or loss. 40% of revenue are constitutive of currencies D, E, F, H, I and J. Currencies D, E, F, H, I and J fluctuate more wildly. So, I recommend company to use foreign option to hedge foreign exchange risk. The reason is that when there is a significant loss, company can choose to exercise option contract to avoid losing too much money. When there is a significant gain, company can choose not to exercise option contract to receive a large amount of gain. Since this multi-national corporation is publicly trade in U.S. All hedging accounting, information and document should be full disclosed on financial report, and then file to SEC to avoid penalty and

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