Free Online Course in International BusinessBalance Sheet HedgingForeign currency options protect against adverse foreign exchange fluctuations while benefiting from a positive movement in the exchange rate. The trader is provided with the right but not the obligation to buy (call option) or sell (put option) a specific amount of foreign currency at a fixed price within a set period. Protection is provided. If the rates are unfavorable to the trader, he will just exercise the option; should the rates be favorable to the trader, then there is no need to exercise the option. Because of its advantages, this process for a right to buy or sell can be expensive. It is generally used for large denominations. Contingent obligations resulting from long contract negotiations could make this an attractive means of controlling exposure risk.Acquisition ActivityAcquisitions take time to conclude and are often in large denominations. The evaluation of an acquisition is difficult enough without the worry of foreign exchange rate fluctuations. Options provide a good hedge against rate fluctuations during the negotiation process.Foreign Exchange TradingThe exchange of one currency for another currency, dollars (USD) for Japanese yen (JPY), is the basic definition of foreign exchange. There are two different types of quotations:• Indirect quotation The price of a national currency expressed in terms of one unit of a foreign currency • Quoting Japanese yen at a rate of 110 • 1 USD = 110.00 JPY • Direct quotation The value of one unit of national currency in terms of the foreign currency • Quoting USD at a rate of .009091 • 1 JPY = .009091 USD. Common Instruments to Offset Risk SpotSpot trades are priced and executed on the spot based on the current market rate and are paid for immediately. Spot contracts are generally done verbally and considered binding. When executing a trade, an offer price is provided; if accepted, the contract is considered done. Delivery of the currency is generally two days forward; the two day's time is used for the bank to receive the currency it purchased and deliver the currency to the beneficiary as provided by the buyer.Forwards Forward contracts are priced by combining the current spot price with the forward points. Forward points are based on the differential in interest rates of the two countries. The discount or premium points, once determined, are combined with the spot rate to create the forward rate. Some currencies are not traded openly, but there is a non deliverable currency market. By hedging with a non deliverable forward, a purchaser can protect against rate fluctuations rather than settling a transaction at maturity using the exchange rate that is posted on that date. Settlement would be in the local currency to provide additional local funds to settle the transaction. SwapsSpot contracts are settled immediately while a forward contract has a fixed maturity and must be settled at maturity. Capital can be tied up when the need to deliver the currency has been delayed. Swaps provide an opportunity to exchange the foreign currency for the local currency for a fixed period of time and "swap" it back when it is needed.
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