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Strategic Financial Managament

In: Business and Management

Submitted By kywoon
Words 3652
Pages 15
Hedging is a risk management strategy used in limiting or eliminating chances of loss from uncontrollable changes in the prices of commodities, currencies, or securities. A hedge is an investment position that used to reduce potential losses that may be occur in an investment for an individual or an organisation. In short, hedging is a transfer of risk without buying insurance policies. Hedge funds are designed to reduce an investment risk while maintaining a good return on investment.

Hedging refers to managing risk to an extent that makes it bearable. In international trade and dealings foreign exchange play an important role. Fluctuations in the foreign exchange rate can have significant impact on business decisions and outcomes. Many international trade and business dealings are shelved or become unworthy due to significant exchange rate risk embedded in them.

Hedging uses various techniques, it involves taking equal and opposite positions in two different markets (such as cash and futures markets). A hedge can be constructed from many types of financial instruments, including forward contracts, future contracts, options, swaps, many other types of over-the-counter and derivative products.

Forward Contracts

Generally, the most prominent instrument used in hedging for exchange rate risk management is the forward contract. Forward contracts are customised agreements between two parties to fix certain condition such as the currency exchange rate, interest rate or commodities price for a future transaction. It gives the buyer an obligation to purchase an asset and the seller an obligation to sell an asset at a specified price at a future point in time.

Assume that a UK construction company, Wates just won a contract to build a new office building in US. The contract is signed for 1,500,000 dollar and would be paid for after the completion of the...

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