Introduction
Exchange rate risk refers to the potential financial loss that a firm may experience due to fluctuations in exchange rates. Firms with international operations or cross-border transactions are exposed to exchange rate risk, which can negatively impact their profits. In order to mitigate this risk, firms use various hedging methods (Berk et al., 2021).
Main Body
One way to hedge exchange rate risk is through forward contracts. A forward contract is an agreement between two parties to exchange a specified amount of currency at a predetermined exchange rate at a future date. Firms can use forward contracts to lock in an exchange rate for a future transaction and reduce their exposure to exchange rate fluctuations. An alternative way to hedge exchange rate risk is through options contracts. Options contracts give the holder the right but not the obligation to buy or sell currency at a predetermined price at a future date (Berk et al., 2021). Firms can use options to protect against adverse exchange rate movements while still allowing them to benefit from favorable exchange rate movements.
Firms may prefer one method over the other, depending on their specific circumstances. For example, a firm may prefer using forward contracts when they have a fixed amount of currency that they know they will need in the future (Sikarwar & Gupta, 2019). In addition, a firm may prefer using options when they are unsure of the amount of currency they will need or when they want to limit their downside risk while still being able to benefit from favorable exchange rate movements.
Conclusion
Thus, a firm’s decision to hedge exchange rate risk will depend on its risk tolerance, the size of the transaction, the length of the hedge, and other factors (Sikarwar & Gupta, 2019). By hedging their exchange rate risk, firms can protect their profits and ensure that they can operate in a stable financial environment.
References
Berk, J. B., De Marzo, P. M., & Hartford, J. (2021). Fundamentals of corporate finance (5th ed.). Pearson Education.
Sikarwar, E., & Gupta, R. (2019). Economic exposure to exchange rate risk and financial hedging: Influence of ownership as a governance mechanism. Journal of Economic Studies, 46(4), 965-984. Web.