Why Companies Use Currency Derivatives?

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Essay topic: why companies use currency derivatives? Currency derivative can be defined as a contract or financial agreement to exchange two currencies at a given rate or a contract whose value is derived from the rate of exchange of two currencies on spot (Shoup, 1998). Currency derivatives are developed and adopted to implement a strategy known as hedging, in which an organisation acquires a contract in order to offset an expected drop or rise in value of a position or future cash flow (Belk & Edelshain, 1997). This essay will outline the incentives and rationales behind an organisation that uses currency derivatives. There are three types of currency derivatives used in hedging, future contracts, forward contracts and options,…show more content…
The second is to combat the unfavourable currency movement by reducing the negative impact of currency exposure (Eiteman et al, 2009). This can be understood by the fact that for an organisation who is involved in international business, exposure to currency fluctuation accounts for the dramatic variance of the organisation’s income and expenses (Cusatis & Thomas, 2005). It is found that forward contracts are normally used to eliminate the variance involved in contractual commitments while option-type contracts are used to reduce the impact caused by uncertain foreign currency denominated future cash flows (Bodnar & Gebhardt, 1999). As in most cases, payment and experiences are contractual obligations, forward contracts are more popular, but for big organisations who have a bigger number of uncertain payments received from overseas customers, options can be also commonly seen (Bodnar & Gebhardt, 1999). In general, an organisation that has a higher level of foreign pretax income is more likely to benefit from hedging in this case (Geczy, et al, 1997). A good example to illustrate this is that assuming Fonterra is to receive a payment from a US customer due in six months, Fonterra might enter a forward contract with the speculation that the NZ dollars will be appreciated during this period (leading to a lower income when the USD-dominated payment is converted into NZ dollars). In this situation, a forward

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