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ACCA Strategic Professional · Advanced Financial Management · The use of financial derivatives to hedge against forex risk

A company expects to receive a foreign currency amount in three months and is unsure whether the contract will be confirmed. Which hedging method is most appropriate?

A currency option is most appropriate, because it gives a right without an obligation. If the contract falls through the company can let the option lapse and lose only the premium, whereas a forward or money market hedge would leave it exposed.

  1. AA forward contract, since it is free and flexible
  2. BA money market hedge, since it is binding but cheap
  3. CA currency option, since it need not be exercised if the underlying receipt does not occurCorrect
  4. DA currency swap, since it removes all timing uncertainty

Explanation

Where the underlying exposure is uncertain, a forward or money market hedge creates an obligation that could become a speculative position. An option can simply be abandoned, limiting the loss to the premium.

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