Hedging Baker Has a Number of Possibilities

Hedging Baker has a number of possibilities for hedging its exposure to the Brazilian real. Two major forms of currency hedging are forward market hedges and money market hedges. A forward market hedge involves purchasing a forward contract for the currency exchange. A forward allows the firm to lock in the price and timing of the transaction, based on expected exchange rate values on the forward market. A money market hedge involves hedging exposure by borrowing and lending in multiple currencies.

Money market hedging involves balancing the differential interest rates and the timing of the currency flows in order to lock in a value for the future cash flow. Both types of hedging essentially serve the same purpose of locking in the value of the future, foreign-denominated cash flow, thereby reducing the risk associated with the foreign currency transaction. Of the two techniques, forward market hedges are more popular for a couple of reasons. Forward hedging is the simpler of the two techniques, because it involves only a single transaction.

In a forward contract, the terms of the contract can be set to meet the exact needs of the company, allowing for the creation of a perfect hedge. Money market transactions are more complex, and may entail higher transaction costs since at least two deals must be executed. For companies, the increased complexity could increase the risk of making a mistake. In addition, it can be more challenging to get a perfect hedge from a money market hedge, because interest rates are being used a proxy for currency prices.

They are correlated, but in practice that correlation is imperfect. In addition, the firm when negotiating the money market hedge would need to have greater knowledge of the underlying political and economic conditions of the two countries than if a forward contract is being executed. There is also the consideration of Baker's borrowing costs. It has already been mentioned that the additional transaction in a money market hedge can play a factor, but for Baker the company's own cost of capital will play a role as well.

A money market hedge involves borrowing in multiple currencies. This can impact on the cost of borrowing, especially if some of that borrowing needs to be done in an obscure currency or worse yet a foreign country. If a Canadian company wants to execute a money market hedge in U.S. dollars, this probably will not cost any extra, but for Baker borrowing in real through a Brazilian bank the costs could be prohibitively high.

Baker has no credit rating in Brazil and is not a large company, so it is likely that Baker's cost of borrowing in Brazil is significantly higher than in the U.S. This would lead Baker towards taking on a forward market hedge instead. 2. A company cannot be certain that it lacks exchange rate risk. There are a number of reasons for this, related to the mechanics of a given hedging strategy.

The most important aspect of exchange rate risk is the volatility of the currency's value, and this is related to the time frame. A forward or any other hedge is priced on the basis of an expected date of future cash flows. If there is any delay in those cash flows, then the firm would still be subject to exchange rate risk. For example, if the Brazilian firm takes an extra week to pay, Baker will have exchange rate risk for that week.

Likewise, if the cash flow itself is different, there are risks associated with that as well. Again, in order for the firm to be perfectly hedged, the flows match up precisely in their amount and timing. When this is not the case, the hedge becomes imperfect. Even a hedge that was perfect when it was first set up could become imperfect.

It could be argued that this is firm risk relating to the partner, or the counterparty in the contract, but the end result for the firm is increased exposure to exchange rate risk. In addition, translation risk is virtually impossible to hedge perfectly. Even when a firm has a perfect hedge on transaction risk, translation risk can still exist in bringing revenues back to the income statement. There are going to be timing differences, for example, between recording revenue is reals today and.