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Designing a hedging strategy using a derivative contract of currency pairing1 Designing a hedging strategy using a derivative contract of currency pairing (CAD/CHF = Canadian Dollar / Swiss Franc) Name Institution Course Professor Date
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Designing a hedging strategy using a derivative contract of currency pairing2 Introduction Different factors have been put in place to ensure that there is free trade across political and distance boundaries. Current technological and political advances promote free trade includes elimination or reduction of subsidization, capital controls and restrictive tariffs of local businesses. Technological advancement is like minimized transportation costs, which has resulted from containerization of goods for shipping and telecommunication advancement lead by the internet. Due to this, a lot of corporates conduct their transaction outside their native country, in the process incurs liabilities or earns revenues denominated in currencies apart from their currency. However, in this process companies are likely to become exposed to the threat that foreign exchange rates fluctuate and is unpredictable in an adverse direction. It is such uncertainties, which make it hard to manage cash flow, to succeed in a competitive market or plan any future corporate expansion. Hedging with FX futures A company faced with a threat of volatile exchange rates has a lot of alternate methods that it can use to address these risks. The most effective and efficient risk management technique is found in CME currency form future contracts. The thing to be considered when it comes to constructing a hedging strategy is the aggregate of the risk exposure in which a company is subjected (Pilbeam, 2013 p. 85). That is instinctive to the level, which the idea of the hedge is to offset any possible adverse fluctuations of price in the market with opposite and equal exposure in the hedging medium like futures.
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Designing a hedging strategy using a derivative contract of currency pairing3 Hedge Ratio identification in the context of forex exchange is a simple link between future contract sizes and the exposure to be hedged. Hedge Ratio = amount of risk exposure/future contract size For example when a given company which is located France, where it’s financial statement is denominated in Swiss Franc, agrees to sell its products and then it is delivered between 1st October to 1st November 2015 after making payment of 50, 000, 000 Canadian Dollar. In this effect, the company is likely to be exposed to the threat of declining CHF vs. CAD. Hedge Ratio = CAD 50 000 000/ CAD 125 000 = 400 CAD/CHF FX futures. An ideal strategy to be used might be to sell CAD/CHF futures to address the threat exposure. Hedge Ratio is achieved by carrying out a comparison of 50 000 000 CAD threat exposure with 125 000 CHF future size of the contract.
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  • Fall '08
  • Ali
  • Exchange Rate, Foreign exchange market, derivative contract

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