As a trading company, Joewoka exports and imports merchandize in many countries for which it receives and makes payment in foreign currency. This exposes the company to foreign exchange risk.
As a Financial Consultant to the company, suggest FOUR approaches that the company can use to hedge against foreign exchange exposure. (5 marks)
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Foreign Exchange risk is the probability that a company will be unable to adjust its prices and cost to offset changes in exchange rates. It also means the risk that the domestic currency value of cash flows denominated in foreign currency may vary due to changes in the foreign exchange rate.
Ways of heading against Foreign Exchange Risk
1. Forward Contract
This involves a contract, which is tailor-made (taken out for the exact amount of currency required. The future exchange rate is fixed at the time the contract is entered in to with the bank. The cost is then determined by the forward rate quoted by the bank.
2. Future Contract
This offers the opportunity to buy/sell currency in standard amount of a limited number of currencies at a specified time and rate.
3. Lead/Lag Payment
In the case of paying for goods in a foreign currency, it is possible to pay for the goods in advance and thereby fix the exchange rate at the spot rate.
4. Currency Options
Here, the firm has the possibility of buying (call) or selling (put) currency at an agreed rate usually at any time within a specified period.