FOREIGN EXCHANGE HEDGING

INTRODUCTION
The price of one currency in terms of another

currency is called exchange rate.

To purchase goods and services produced by the
residents of another country generally requires
first purchasing the other country's currency.
This is done by selling one's own currency for the
currency of the country with whose residents you
desire to transact. More formally, one's own
currency has been used to buy foreign exchange,
and in doing so the buyer has converted his
purchasing power into the purchasing power of
the seller's country.

INTRODUCTION.
Different countries issues different currencies and

the relative values of currencies may change

quickly, substantially, and without warning.
This is to say that, exchange rate are highly
volatile.
The exchange rate affects the economy of the
country, the companies and our daily lives,
because when Tanzanian shilling becomes more
stronger relative to foreign currencies, foreign
goods become cheaper for the citizens of
Tanzania and the Tanzanian firms enjoys low
costs of spare parts and raw materials from
foreign countries, but Tanzanian goods become
more expensive for foreigners in foreign market.

 When Tanzanian shilling falls in value, foreign

goods become more expensive for the

Tanzanians and goods made in Tanzania will be
cheaper for foreigners.
Also when Tanzanian shilling falls in value the
higher prices of foreign products push up the
price level and inflation of the country e.g fuel
prices.
At the same time that fall in value of Tanzanian
shilling makes Tanzanian products cheaper for
foreigners, increasing the demand for Tanzanian
goods and therefore stimulate production and
output.

TYPES OF RISK EXPOSURE

Movements of exchange rate affects the firms doing

transactions with other firms outside borders and

therefore any firm that is engaged in foreign-currency
denominated transactions is exposed to exchange
rate risk
There are three main types of exchange rate risk
exposure.
1. Transaction risk
Which is basically cash flow risk and deals with
the effect of exchange rate movements on
transactions related to receivables (export
contracts), payables (import contracts). An
exchange rate change in the currency of
denomination of any such contract will result in a
direct transaction exchange rate risk to the firm

 2. Translation risk
o This is the risk that occurs when assets and

liabilities denominated in a foreign currency in a

subsidiary company need to be translated to a
parent companys domestic currency for
accounting purposes.
o The conversion normally results in foreign
exchange gains or losses. This is of particular
concern to parents companies that have foreign
subsidiaries and want to consolidate a foreign
subsidiary to the parent companys balance sheet.
So this is basically a balance sheet exchange rate
risk.
o In consolidating financial statements, the
translation could be done either at the end-of-theperiod exchange rate or at the average exchange
rate of the period, depending on the accounting

TYPES OF RISK EXPOSURE

3. Economic risk

o This is the risk that relates to the overall

impact that exchange rate fluctuations can

have on a companys value. Companies
that only sell domestically can also face
economic exposure when, for example, the
domestic currency strengthens and
improves the competitive position of
foreign producers.
o Economic risk therefore reflects the risk to
the firms present value of future operating
cash flows from exchange rate movements

HEDGING
It is important for the firms that are involved in

foreign currency transactions to protect

themselves against exchange rate exposure.
This can be done through the process known as
foreign exchange hedging. Foreign exchange
hedging is the act of entering into a financial
contract in order to protect against unexpected,
expected or anticipated changes in currency
exchange rates.
Foreign exchange hedging therefore is used by
financial investors and businesses to eliminate
risks they encounter when conducting business
internationally

EXCHANGE RATE EXPOSURE

TECHNIQUES
The aim of Foreign exchange hedging is to stabilize

the cash flows and reduce the uncertainty from

financial forecasts.
Various techniques for managing the exposure are as
follows
Derivatives
o A derivatives transaction is a contract (or
payment exchange) agreement whose value
depends on the value of an underlying
reference rate . Every derivatives transaction
is constructed from two simple building blocks
that are fundamental to all derivatives
forwards and options.
o They include forwards-based Derivatives
which contains three divisions of forwards-

EXCHANGE RATE EXPOSURE

TECHNIQUES.
The Forward Contract hedge
o Under this contract (obligation)the firm

may sell (buy) its foreign currency

receivables (payables) forward by setting
the exchange rate today in order to
eliminate its exchange risk exposure.
o In quoting the forward rate of currency, a
bank will use a rate at which it is willing to
buy the currency (bid) and a rate at which
it will sell a currency (offer) for delivery,
typically one, two, three or six months after
the transaction date. Setting up foreign
contract hedge involves no upfront costs

EXCHANGE RATE EXPOSURE

TECHNIQUES.
Swaps

o This is an agreement to exchange one

currency for another at a predetermined

exchange rate known as the swap rate.
o This method suits the films which often
have to deal with sequences of accounts
payables or receivables in terms of a
foreign currency. Swaps are very flexible in
terms of amount and maturity; the maturity
can range from a few months to 20 years.

EXCHANGE RATE EXPOSURE

TECHNIQUES.
Futures Contracts
o This is the contract that requires a firm to sell

or buy its foreign currency at standard contract

sizes, time periods, settlement procedures and
is traded on regulated exchanges.
o An agreement to make or take delivery of a
standard quantity of a specific foreign currency
at a specified future date and at a price agreed
on an Exchange.
o This method (just like Forward contract)
completely eliminates exchange rate risk
exposure but also( like forward contract) the
firm has to forgo the opportunity to benefit
from favorable exchange rate changes

EXCHANGE RATE EXPOSURE

TECHNIQUES.
B. Options
o A foreign currency option is a contract giving the

option purchaser (the buyer) the right but not the

obligation, to buy or sell a fixed amount of foreign
exchange at a fixed price per unit for a specified
time period.
o Currency options therefore provide such a flexible
optional hedge against exchange exposure.
o The firm may buy a foreign currency call (put)
option to hedge its foreign currency payables
(receivables) or choose not to exercise the option
and let it expire is the prevailing foreign currency
rate are favorable to them as compared to the rate
contained in option contract.

EXCHANGE RATE EXPOSURE

TECHNIQUES.
o Or is a contract which has one or other of the two key

attributes
o An Option to buy (call option) - It is a contract that gives the

buyer the right, but not the obligation, to buy a specified

number of units of foreign currency from the seller of option
at a fixed price on or up to a specific date.
o Option to sell (put option )-

It is a contract that gives the buyer the right, but not

the obligation, to sell a specified number of units of
commodity or a foreign currency to a seller of option
at a fixed price on or up to a specific date.
o Option can be classified as American Option or as
European option. The holder of an American option
has the right to exercise the contract at any stage
during the period of the option, whereas the holder of
a European option can exercise his right only at the
end of the period.

OTHER TECHNIQUES
Invoice currency exchange hedging
o This is the process whereby firm can shift,

share or diversify exchange risk by appropriately

choosing the currency of invoice
for example a Tanzania firm can invoice in
Tanzanian shillings rather than Rwandese franc
to a Rwandan firm for the sale of the products .
o Here Tanzanian firm does not face exchange
exposure anymore.
o But the exchange risk has been shifted to a
Rwandese importer and now a Rwandese firm
has account payable denominated in Tanzanian
shillings. Also the two firms can agree to share
the exchange rate exposure by the pre agreed
margins

OTHER TECHNIQUES
As a practical matter, however the firm may not

be able to use risk shifting or sharing as much as

it wishes to for fear of losing sales to competitors.
Also if the currencies of both the exporter and the
importer are not suitable for settling international
trade, neither party can resort to risk shifting or
sharing to deal with exchange exposure.

OTHER TECHNIQUES
Leading and Lagging
o Another operational technique the firm can

use to reduce transaction exposure is leading

and lagging foreign currency receipts and
payments. To lead means to pay (or
collect) early, and to lag means to pay (or
collect) late.
o The firm would like to lead soft currency
receivables to avoid the loss from
depreciation of the soft currency and lag hard
currency receivables in order to benefit from
the appreciation of the hard currency. For the
same reason, the firm will attempt to lead the
hard currency payables and lag soft currency

OTHER TECHNIQUES
Leading and Lagging
o If lead/lag strategy are effectively

implemented then firm can manage to reduce

transaction exposure. The lead/lag strategy
can be employed more effectively to deal
with intra firm payables and receivables, such
as material costs, rents, royalties, interests,
and dividends, among subsidiaries of the
same multinational corporation. It is difficult
to implement these techniques to firms with
import export relationship due to existence of
competitions in the market and the exporting
firm would fear losing the future market.

OTHER TECHNIQUES
Netting
o Netting means consolidation of all exposed

inflows and outflows for a particular time and

currency.
Matching
o A firm that has an ongoing inflow of foreign
currency as accounts receivable, can borrow the
same currency so as to have a matching
accounts payable (interest and principal) as a
natural hedge.
o Or a firm that has an ongoing outflow of foreign
currency as accounts payables can
simultaneously use its account receivable to
match with that account payable when they due.