Forex hedging pdf

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Therefore the investor's hedging strategy itself generates an additional risk, which in turn induces the need for additional hedging. Yazid and Muda studied the usage pattern of foreign exchange management strategies in multinational corporations. They found that multinationals are involved in foreign exchange risk management primarily because they sought to minimize operational overall cash flows, which are affected by currency volatility.

Also, the majority of multinationals centralize their risk management activities and at the same time impose greater control by frequent reporting on derivative activities.

It is likely that huge financial losses related to derivative trading in the past led to top management being extra cautious. Dash et al. On the other hand, for currency inflows, hedging with forward currency contracts would yield the highest mean returns for a decreasing trend in the exchange rate, cross currency hedging would yield the highest mean returns for a cyclic fluctuation in the exchange rate, however, for an increasing trend in the exchange rate, no single hedging strategy would yield the highest mean returns.

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They also concluded that it would be an added advantage for one to use a combination of strategies to manage foreign exchange exposure. The present study has extends the analysis of Dash et al. However, unlike the approach in Dash et al. Walmsley discussed the enormous changes which have occurred during the past few years in foreign exchange markets and the impact they would be expected to have on the nature of international business.

He proposed a non-linear model for exchange rate dynamics, based on a long-run equilibrium level and shocks, with mean-reversion. Still discusses crowd dynamics and chaotics in the Forex market. He linked Walmsley's exchange rate dynamics model with the logistic function, and examined the chaotic properties of the model. Data and methodologyThe present study extends the analysis of Dash et al. Based on the results of the simulation of this model, the hedging strategies which yielded the highest returns and the lowest variability of returns could be identified.

The model used in the study to simulate the exchange rate dynamics was adapted from Walmsley The long-run equilibrium exchange rate denoted by S' is determined by such factors as relative money supply, output capacity, and so on, and can be assumed to be constant for the short run. This simulation model was validated with the exchange rates of different currency pairs for the period of ten years.

The analysis was carried out with a fixed series of cash flows, expected to be received at fixed time points within a six-month interval. The results are based on two hundred and fifty simulation runs of the above model. It was found that forward hedging yielded significantly lower mean value of cash flows than options hedging.

Finally, it was found that the unhedged position yielded significantly lower mean value of cash flows than the other strategies. In terms of volatility, it was found that forward hedging and options hedging had lower variability than the unhedged position, while it was found that cross-currency hedging had higher variability than the unhedged position. Comparative analysis of hedging strategies for USD outflows for six months. The next sample on which the different hedging strategies were applied was a series of cash inflows, as shown in the table below.

Exchange rate dynamics and Forex hedging strategies

The results of the simulation are shown in Table 2. It was found that forward hedging and cross-currency hedging yielded significantly lower mean value of cash flows than without hedging.

In terms of volatility, it was found that options hedging had lower variability than the unhedged position, while it was found that cross-currency hedging had higher variability than the unhedged position. The third sample on which the different hedging strategies were tested was a series of cash inflows, as shown in the table below. The results of the simulation are shown in Table 3.

It was found that there was no significant difference in the mean value of cash flows under forward hedging and cross-currency hedging. In terms of volatility, it was found that options hedging had similar variability as compared with the unhedged position, while it was found that cross-currency hedging had higher variability than the unhedged position. In particular, the results of the study show that it is always risky to remain unhedged against foreign exchange rate fluctuations.

Of course, much would depend on the risk-tolerance of the concerned firm. If a firm is absolutely riskintolerant, forwards would be the most appropriate hedging instrument. In such a case, one should analyze inflation rates and interest rates to make sure that the forward rates are properly priced, both to construct better hedges and to take advantage of any mispricing. On the other hand, if the firm is able to take risk and wants better returns, it could hedge cash inflows by cross currency hedging.

Again, the outcome of cross-currency hedging depends critically on the choice of third currency.

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Further research should examine the conditions under which different currencies would yield better results in crosscurrency hedging. From the results of the study, hedging with out-ofthe-money currency options contracts was found to result in the highest mean returns, irrespective of the movement of the exchange rate. This seems to contradict the results of Albuquerque Albuquerque , and the results of Dash et al. There were some mild limitations inherent in the study. The data for the study was for the period of ten years only, which may not be comprehensive enough to come at a conclusion.

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Further, the study used a simple non-linear model for exchange rate dynamics; more complex models would improve upon the results of the present study. The volatility in foreign exchange risk is influenced by change in economic newlineperformance of various economies in terms of their GDP, inflation rate, fiscal deficit, newlineemployment rate, position in world trade etc. The business firms having international newlineoperations are directly affected by change in currency exchange rate.

The currency newlinerisk or Forex risk is understood as possible loss to payment of international newlinetransactions due to unfavorable exchange rates. Ideally, companies of all sizes small, newlinemedium and big are equally affected by Forex rate fluctuations. But there is newlinediversity in this opinion too.

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