Explain and assess the techniques firm could use to hedge against exposures it faces.

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krishna-agrawala | College Teacher | (Level 3) Valedictorian

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I believe, the exposure referred in the question pertains to exposure to risks resulting from fluctuations in market price of commodities such as, say, copper or silver used as raw material. or due to fluctuations in exchange rates of foreign currencies.

Let us say a diamond trader in India has sold diamonds worth 1 million dollars to a firm in USA, and payment for this is to be made by the USA firm after 3 months. If the exchange rate of dollars and rupee after 3 months is such that rupee depreciates in value in relation to dollar than the net realization of the company in rupees will increase. However, if the rupee appreciates in value in relation to dollar than the net realization of the company in rupees will decrease. If this company wants to avoid this uncertain outcome after 3 months it can do so by hedging.

In hedging a firm or an individual enters in to a future transaction that cancels out the impact of the original transaction that will take effect at the same time. For example, the diamond trader referred in above paragraph can enter into a contract to sell 1 million dollars to a foreign exchange trader after three months at a fixed price. After 3 months when the diamond trader receives the payment of 1 million dollar from his customer, the same is delivered to the foreign exchange trader, and rupees are received in exchange at the agreed rate. Thus the diamond trader receives a fixed amount

As a result, whatever be the exchange rate after 3 months the trader receives the same amount of payment in rupee irrespective of exchange rates at that time.

Hedging, is good because it eliminates losses due to market rate fluctuations. However it also eliminates likely gains due to these fluctuations. Plus there is always a small charges associated with the additional hedging transactions. Hedging is recommended in all situation where the the maximum likely loss too big for the firm absorb easily. Also the firms that prefer to concentrate on their main business and do not want to get into intricacies of understanding and forecasting market fluctuation will benefit from using hedging.

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