Exchange Rate Mechanisms - Currency Hedging

Exchange Rate Mechanisms Paper - Currency Hedging

University of Phoenix

Global Business Strategies

MGT 448

Oct 05, 2005

Exchange Rate Mechanisms Paper - Currency Hedging

Currency hedging involves deliberately taking on a new risk that offsets an existing one, thereby reducing a businesses’ exposure to negative change in exchange rates, interest rates, or commodity pricing (Economists.com, n.d.). “Currency hedging allows a business owner to greatly reduce or eliminate the uncertainties attached to any foreign-currency transaction” (Fraser, 2001). It is impossible to predict the how much a currency will be worth on the exact day that a company will be converting it. With hedging, the uncertainly is gone. Many companies that have international operations are constantly juggling multiple transactions, with payments that are staggered and tied to the swing of a number of currencies.

There are a growing number of banks as well as business to business websites that offer currency hedging, regardless of company size. It used to be that the only way to truly avoid the risk of currency fluctuation was to transact all international business in U.S. dollars. For small companies, especially, it would be hard to insist on these terms (Economists.com, n.d.). There are a number of currency hedges, including: spot contract; forward transactions; options; currency swaps; and non-deliverable forwards (Wachovia, n.d.).

Spot contracts are a way of converting currency from another country into U.S. dollars or for making a payment in foreign currency. Currency can be bought at today’s exchange rate, and in most cases, the final settlement occurs in two days. Forward transactions are very popular, especially for those just getting into currency hedging. Forward transactions allow a company to buy or sell a currency at a fixed rate at a specified future date. This essentially locks in the exchange rate that an organization wishes to use, and eliminates risk (Wachovia, n.d.). “Options are contracts that guarantee, for a fee, a worst-case exchange rate for the future purchase of one currency for another” (Wachovia). Options are different from foreign contracts in that the buyer is not obligated to deliver the currency on the settlement date unless the option is exercised. Currency swaps are a way for companies with recurring cash flows in a foreign currency, or a company that is seeking financial backing in a foreign country. Lastly, in a market where forward market does not exist or is restricted, although like a forward transaction, a non-deliverable forward makes it possible to hedge future currency exposure (Wachovia). It should be noted that this type of hedge is settled in U.S. dollars.

The text cites the case of Japan Airlines (JAL), which is one of the world’s largest airlines and a huge customer of Boeing (Hill, 2003, p. 307). Boeing aircraft are priced in U.S. dollars, and those ordering normally pay a 10% deposit. When JAL purchases aircraft from Boeing, it must change its yen into dollars. The length of time between ordering the aircraft and taking delivery can be up to five years, and the value of the yen can change in that time period. When placing the order, JAL has no way of knowing what the value of the yen will be against the U.S. dollar in five years, therefore, one way of mitigating this risk was to enter into a forward exchange contract (Hill). JAL entered into a ten-year agreement worth approximately $3.6 billion that gave JAL the ability