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- 5 Marks
Question
b) As a trading company, Joewoka exports and imports merchandise in many countries for which it receives and makes payment in foreign currency. This exposes the company to foreign exchange risk.
As a Financial Consultant to the company, suggest FOUR approaches that the company can use to hedge against foreign exchange exposure. (5 marks)
Answer
Approaches to Hedge Against Foreign Exchange Risk:
- Forward Contract
- A contract made with a bank to buy/sell currency at a predetermined rate on a specific future date. This method fixes the exchange rate, thus providing certainty.
(1 mark)
- A contract made with a bank to buy/sell currency at a predetermined rate on a specific future date. This method fixes the exchange rate, thus providing certainty.
- Future Contract
- Similar to forward contracts, but futures are standardized and traded on exchanges. They help companies hedge currency risk by locking in exchange rates for specific future transactions.
(1 mark)
- Similar to forward contracts, but futures are standardized and traded on exchanges. They help companies hedge currency risk by locking in exchange rates for specific future transactions.
- Lead/Lag Payments
- Payments for goods/services can be expedited (lead) or delayed (lag) to benefit from favorable exchange rate movements. By adjusting payment timing, companies can minimize currency losses.
(1 mark)
- Payments for goods/services can be expedited (lead) or delayed (lag) to benefit from favorable exchange rate movements. By adjusting payment timing, companies can minimize currency losses.
- Currency Options
- Provides the right, but not the obligation, to buy (call) or sell (put) a currency at an agreed rate within a set time. It allows companies to hedge risks while benefiting from favorable rate movements.
(1 mark)
- Provides the right, but not the obligation, to buy (call) or sell (put) a currency at an agreed rate within a set time. It allows companies to hedge risks while benefiting from favorable rate movements.
- Natural Hedging
- Involves offsetting foreign currency exposures by matching foreign currency revenues and costs. For example, revenues in one currency can be used to pay liabilities in the same currency.
(1 mark)
- Involves offsetting foreign currency exposures by matching foreign currency revenues and costs. For example, revenues in one currency can be used to pay liabilities in the same currency.
- Tags: Currency Hedging, Foreign Exchange Risk, Hedging, Risk Management, Risk Mitigation
- Level: Level 3
- Uploader: Dotse