The methods to hedge the exchange rate risk

According to the empirical studies, the researchers concluded that it is difficult to predict the exchange rate movement, although many forecasting techniques have been developed. There is still uncertainty about the value of a currency in the future. This will bring the exchange rate risk for the MNCs. The implementation of purchasing power parity, the investor hedge argument, currency diversification argument, and stakeholder diversification argument lead to the irrelevant of exchange rate risk (Madura and Fox, 2007). However, the response from MNCs proves that they believe exchange rate risk is relevant, because the MNCs could stabilize their earnings over time by hedging their exchange rate risk (Madura, 2010). Therefore, it is clear that hedging the exchange rate risk is substantial for MNCs.

There are some techniques that could be used by the MNCs to hedge the exchange rate risk, which could be seen as follows:

1.   Future Hedge

The future hedge consists of two ways of hedging: purchasing and selling currency futures. The future hedge leads the MNC to buy or sell a currency futures contract and entitles the MNC to receive or sell “a specified amount in a specified currency for a stated price on a specified date (Madura and Fox, 2007: p.391).” Employing this hedging method will decrease the risk of exchange rate fluctuation in the future by locking the amount of the currency.

2.   Forward Hedge

The forward contract also has the same function with the future contract. However, the forward contracts are commonly used by large companies and for a large transaction (Madura, 2010). The using of this method leads the MNCs to negotiate the forward contracts with specifying the exact number of units that they require. Shapiro (1994) points out that the difference between future and forward contract is that the futures contracts are standardized contracts traded on an organized exchange, whereas the forward contracts are non-standardized private deals. Nevertheless, Shapiro (2010) argues that these hedging methods also have negative effect, because these contracts could eliminate the possibility of gaining a profit from favorable exchange rate movement.

3.   Money Market Hedge

The method to hedge the payables in the money market is to borrow a local currency, convert to currency denominating payables, and invest these funds until they are needed to cover the payables. In order to hedge receivables, the MNCs could borrow the currency denominating the receivables, convert it to local currency, invest these funds, and then pay off the loan with cash inflows from the receivables (Madura, 2010). This method considers the comparison of the exchange rate value and the interest rate between two countries involved.

4.   Currency Option Hedge

According to Shapiro (2010), the currency options give the holders the right, but not obligation, to put (sell) or call (buy) the currency contract at a set price and expiration date. Currency options provide a benefit for the MNCs to avoid the risk of exchange rate movements. However, “Company must assess whether the advantages of a currency option hedge are worth the price (premium) paid for it (Madura, 2007: p. 398).”

In order to find out more about how these hedging techniques are employed for the MNCs we need to create scenario, illustration, and assumptions. Therefore, we could observe and compare the methods that MNC’s could use to hedge the exchange rate risk arising from the foreign direct investment. Every each method gives different value in which depends on its risk and return. The best decisions of choosing the hedging method will be guided by the company policy (Madura, 2007).

In addition, the previous research from Smith and Stulz (1985) develops the positive theory of hedging behavior of value-maximizing corporations. They argue that the value-maximizing firm could hedge because of three reasons: taxes, financial distress cost and managerial risk aversion. Furthermore, Bessembider (1991: p.519) states “the risk hedging could improve the firm value if hedges increases the operating profits.” To sum up, there are various methods that the MNC could use to hedge the exchange rate risk, however, the MNCs should consider the consequence of every hedging decision made.

References

Bessembinder, H. (1991). Forward Contracts and Firm Value: Investment Incentive and Contracting Effects. Journal of Financial and Quantitative Analysis. 26(4).p.519-532.

Madura,J. & Fox, R. (2007). International Financial Management. Singapore: Seng Lee Press.

Madura, J. (2010). International Corporate Finance. 10^th ed. China: China Translation & Printing Services, Ltd.

Shapiro, A.C. (1994). Foundations of Multinational Financial Management. 2^nd ed. USA: Allyn and Bacon.

Shapiro, A.C. (2010). Multinational Financial Management. 9^th ed. USA: John Wiley and Sons, Inc.

Smith, C.W. & Stulz, R.M. (1985). The Determinants of Firms’ Hedging Policies. Journal of Financial and Quantitative Analysis. 20(4).p.391-405.