Firm with foreign currency risk exposure should hedge the risk using derivatives
or operationally. Explain.

Question

Firm with foreign currency risk exposure should hedge the risk using derivativesor operationally. Explain.

Kushal · Accepted Answer

Firms with foreign currency exposure should hedge the risk.
Firms which do have operations across the countries are subject to foreign currency risk. Any adverse movements in the exchange rates due to any reason might lead to decrease in the revenues or costs in the home currency which would lead to impact in the profitability. So even thought the firm’s operations are going well, the profits might decrease. 
In order to avoid this, a firm can do two things as follows –
Hedge risk by derivatives – When firms hedge the risk of foreign currency by entering into derivatives contracts, they lock in the exchange rate right in the beginning(Petersen, M.A. and Thiagarajan, S.R., 2000). They take opposite position to adverse movement in the currency. Hence, any losses in the operations due to adverse currency movements would be offset by gains in the derivatives contracts. The firm can enter into futures, forwards or options based on their views on the exchange rates. Entering into derivatives contacts lead to increased cash flow risk due to mark to market method and any losses would be an outflow. This needs to be taken care.
Apart from this, there is another method to lock in the rates by entering into money market hedge where you borrow in one currency and invest in another at money market rates. Whenever the payment needs to be maid in foreign currency or it is received, based on the risk, that amount can be withdrawn or deposited into money markets. Based on the past evidence,

Firm with foreign currency risk exposure should hedge the risk using derivatives or operationally. Explain.

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