The key advantages and disadvantages in making a hedging decision

Hedging means to secure against the loss from innumerable risks that rises in worldwide finance market. The term Hedging relates to offset the various risks springing in market through several types of action. Apply to exchange risk, hedging means to alter the composition of assets and liabilities so as to fully or partially offset an existing or potential exposure to the exchange liabilities in overseas currencies . Some of the hedging methods are internal (example matching & netting, leading and lagging, balance sheet hedging, price consideration and money market hedge) i.e. actions taken within the company to reduce company risk without resorting to outside financial institutions & external methods (which involves the use of outside contacts purchased from banks or exchanges example forward contracts & currency options) and these external methods are aimed at insuring against the possibility of losses that internal hedges were not able to eliminate.

Forward contracts This is one of the most commonly hedge techniques used for external environment. Foreign exchange contract is firm and binding agreement between two financial institutions or between a financial institution and a customer to exchange one currency from another at a future date.

As in this given case KENNEDY Plc. a manufacturing company based in South Africa who trades with US companies has due payments of 3 months to be received from its customer and on the other side the company has to make some payments to its suppliers. It is very clear that company might suffer loss if the value of one rand depreciates against 1 pound. So in this situation company can easily gain advantage by using a forward contract hence protecting itself from unfavourable exchange rate situation. There are some other advantages of forward contract like they cater diverse type of commercial and financial transaction and both the parties entering into a contract make use out of it.

Contrariwise, forward contracts have some disadvantages like – What if the exchange rate shifts in a favourable direction? Applying forward contract in this situation can result where it would have been better to remain unhedged. The above question will be clearer by referring to the following example.

For Example a UK company importing goods from Switzerland. A UK company can lock in the cost of buying SFr six months from now. The company enters into a agreement today to purchase SwFr500000 in six months at SFr 1.54 per . This agreement would require the company to pay 324,675(SwFr500000/1.54). This is the price the company will pay no matter how exchange rate moves. They have removed the potential for losses due to weakening of sterling. However the opportunities for profit have also been removed. If the strengthens over the period to Swfr 1.60/ 1 the company would have been better purchasing the Swfr in the spot market and will have lost 12,175 (Swfr500,000 * 1.60 1.54) through taking out the forward contract. This is clearly an opportunity loss and the UK Company would have appeared to make wrong decision, however this can only be judged with hindsight and the company has removed the foreign currency risk.

Money market hedge- Money market hedge implicates instantaneous borrowing and lending actions in two diverse currencies to latch in the value of a future FX currency cash flow. As in the given case, if Kennedy decides to go for a money market hedge then the first step would be borrowing certain amount of dollars for 3 months so that on the day of payback ,the amount should be $10 million which is the netted amount calculated today & Kennedy will be having in 3 months and the next step would include the conversion of dollars into Rands and then investing those Rands for three months. Hence the approach must be considered by the company when the need to hedge coincides with the need to borrow (Heinz Riehl, Rita M. Rodriguez, 1983)

Advantages and disadvantages

This approach is also a beneficial hedge against market falloffs. Let us say an investor is bearish on the stance for the bond or stock market. The investor could then liquidate his investment and choose to obtain a check for the proceeds.

Liquidity

Conceivably liquidity is the most attractive and advantageous feature of the money market. The reason is because of the uncountable individuals observing to invest their assets, funds or capital as a hedge. That implies that the investor will not have much woes to convert the funds into cash or to liquidate the money market position is easy.

Risks

In case of money market the risk factor is comparably low or it is one of the innocuous places for the investment of capital. After all, investments are done in fairly secure government. Customarily, actual risk is characterised with an opportunity cost or the risk invested in a money market could have coped better in some other investment vehicle like stock or a bond. Also, sometimes money market funds can be unsuccessful to keep pace with inflation which suggests that each year, purchasing power of investor may even if investor is fully capitalised. Therefore, seldom it is logical to put all funds into the money market for long duration.

Buying In

Most dealers will provide investors the choice of “sweeping” proceeds from a bond or stock sale into the money market account hence the investors may so that they may get interest when their money is in indeterminate state . Disadvantage is that income of money market may be taxed as gain acquired in short term

Though the money market most likely will not make the investor opulent but it may not even overtake inflation by a outsized margin. It is a good account to invest money while holding oneself for other opportunities to come and for hedging a fraction of collection against market falloffs.

Doing Nothing- The third option is in which Kennedy Co is taking no action or the company decided to not hedge the risk (i.e. to do nothing) and the company gain sometimes and loose the other times because of changes in exchange rate. It is totally up-to the company, if it feels that it has that much creditability and has a good credit to carry itself over, until the situation improves. Only if the company feels it can live with the ups and downs that it should leave foreign exchange risk management alone. On average, over a long period of time the gains and losses should average out at zero. For example, in the time between, contracting to make a payment for inputs and making the payment the foreign currency may go up or down, and in a rationale market each direction should have the equal probability. Some people think the zero average hides a lot of what might be going on. Indeed, economics have been criticized for having one foot in the freezer and one foot in the oven and saying that the average things are just about right (H R Machiraju 2002). Also company may follow this doing nothing action if it determines that exchange rates are minor in comparison with the other factor which influences company performance.

Another factor is the time period in which exchange rates tend to roll. Longer the period, more the company has to deal with the risk and in that situation it is better to go with a hedging policy. Foreign exchange risk not only depends on exposure, but also on volatility of exchange rates. Consequently it is better for a company to do nothing when it seems that the exchange rates are fixed and seem likely to remain fixed. For Ex. Hong Kong dollar has not changed in value against the US dollar for nearly two decades. With their huge foreign exchange reserves and restrictions on who can buy and sell their currency, the people s republic of china has been able to enjoy long periods of ex-change rate stabilities. This has enabled Chinese companies to do business without great fear of exchange-rate-losses.

Therefore, in third case, after three months company will be going blindly to convert the net amount of US $ (due in three months) into Rands at the spot exchange rate (US$10 million * 7.9), and the only advantage is No transaction cost which means neither the company has to buy any financial options (call option, put option etc.) by giving premium, nor has to enter into future or forward contract. Consequently, the company can think of this option if it has sufficient capitalization to handle anything that is likely to hit it.

According to me, the best strategy rather than a perfect strategy for Kennedy plc will be going for a Forward contract as the Co. is making more number of Rands through forward market methods (Rand 81 million) in comparison with other two methods – money market (Rand66.9175 million) and in doing nothing – (Rand 79 million). Hence the suggestion for Kennedy is to play safe and go for a forward contract.

H R Machiraju (2002). International Financial Markets and India. 2nd ed. New Delhi, India: New Age International Publisher. 94.

Maurice D. Levi (2005). International Finance. Glasgow: Routledge. 261-262

Heinz Riehl, Rita M. Rodriguez (1983). Foreign Exchange and Money Markets. USA: The Kingsport Press . 335-336.

Glenn Curtis. Get A Short-Term Advantage In The Money Market . Available: http://www.investopedia.com/articles/pf/06/shorttermmoneymarket.asp. Last accessed 27th Nov 2010.