To what extent does a currency forward contract need to play a formal role in multinational companies? A globalisation has risen over the last 20 years. Because of this factor, international markets have increased rapidly, therefore a large number of companies have been particularly interested in global operatings, such as, export trade, import trade, overseas sales (Moosa, 2003). A subsequent significant trouble looming large for multinational firms is a fluctuation of exchange rate because generally international transactions denominate in foreign currency.
This state makes it clear that international organizations are confronted with profit or loss from unpredictable exchange rates whereas companies, which process transactions in their country, do not (Barumwete & Rao, 2008). This essay will examine how a currency forward contact is applied to reduce exchange rate risks in volatile value of currency situations plus how favorite currency forward contracts are, compared to futures contracts. Risk can be defined as an unscheduled movement that generates unfavorable effects on value or profitability of corporations (Barumwete & Rao, 2008).
In addition, an exchange rate can be described as value of a particular currency that can be converted to another currency (ibid). Therefore, Shapiro (2006) identifies a foreign exchange rate exposure as “a measure of the potential changes in a firm’s profitability, net cash flow, market value because of change in exchange rate. A tool that can eliminate or reduce unwanted section of risk can be defined as a derivative (Hillier, 2010) As a global organization, it is well established that a considerable issue, which may occur after processing international business transactions by using foreign currency, is an exchange rate risk.
This is because when companies operate internationally, sometimes different currencies are utilised to process activities. The common objective of establishing a company is making profits. However, a fluctuation of exchange rate is one factor that affects profit. Eiteman et al (2007) states that a greater number of firms make an effort to evaluate, control and manage impacts of an exchange rate. In this case, a hedging instrument is applied to decrease the risks from an unexpected exchange rate fluctuation.
In other words, “the main purpose of a hedge is to reduce the volatility of existing position risks caused by the exchange rate movements (Barumwete & Rao, 2008, p. 8). Data from Bank of England (2012) shows the value of US Dollar against Pound Sterling had oscillated extremely between $1. 3647 and $2. 1105 per ?1 over 5 years (Figure 1). This volatility of exchange rate can be hedged by these derivative instruments, namely, currency options, foreign exchange forward contracts, currency futures contracts and currency swaps.
In 1994, Phillips (1995) shows an instrument is the most utilised. As a result, a currency forward contract is the most preferable instrument that covered 52. 58% of 291 American companies, which use derivatives to hedge foreign exchange rate risk- from 415 returned surveys of 657 organization that apply at least one of those hedging. Whereas, among those 291 firms, adoption rate of swaps, options and futures accounted for 21. 65%, 19. 93% and 5. 84% respectively (Table 1).
Moreover, Belk and Glaum (1990) , Rumby and Jones (2003) and Geczy et al (1997) state that the most favorite approach utilized to protect exchange rate risk is a forward contract. The reasons for this result will be described later. Phillips’ statistic (1995) shows 70% of international organisations apply derivatives and more than half of samples use currency forward contracts, this result appears to suggest that currency forward contracts are needed to play a formal role in multinational firms .
Currency Forward Contracts can be defined as an approval to trade a currency in these three fixed conditions namely, date, exchange rate and amount (Barumwete & Rao, 2008). A forward exchange rate is a rate that is decided in advance. “The amount of transaction, the transaction date, and the exchange rate are all determined in advance where the exchange rate is fixed on the date of the contract but the actual exchange takes place on a pre-determined date in the future” (Barumwete & Rao, 2008). This means currency rate risks can be mitigated as acceptable conditions in future.
According to Belk and Glaum (1990) , Rumby and Jones (2003) and Geczy et al (1997), currency forward contracts are the most preferred approach, applied to relieve an exchange rate risk . These following issues can be seen to explain why currency forward contacts are dramatically more preferable than futures (the difference between these two figures is approximately 45% (Phillips, 1995, P. 119)). Firstly, forward contracts can be generated in any amount of money, wanted currency, any maturity date whereas futures contracts’ conditions are fixed, such as amount of money, currency and date (Lumby & Jones, 2003).
Secondly, currency forward contracts can be generated in required currency while using future has limited range of currencies, as US Dollar/Pound Sterling, US Dollar/Yen and US Dollar/Euro. This means forwards have more variation of currency rather than futures (ibid, P. 621-P. 622). Lastly, The amount of each future contract is fixed (ibid, P. 622). For example, “US Dollar/Pound Sterling contracts are for ?25,000 each” (ibid). Forward contracts are more suitable for global corporations. These three reasons cannot be overstated as there is no limitation in currency forward contracts.
In other words, forward contracts are more flexible than counterparts. On the other hand, there is a significant issue that should be considered is cost of transaction. A forward fee, which is less than $500,000 per contract is likely to be more expensive than a futures contract. Therefore, some companies that have a large amount of sales prefer a future contract. This point is another circumstance to be considered (Lumby & Jones, 2003). In addition, a currency fluctuation can be preferable or unexpected.
This means companies cannot change any fixed exchange rate even if an exchange rate is more favored. There are two main advantages of using forward contracts. Firstly, according to objective of hedging, unwanted risk is reduced. In addition, this is the most significant benefit of use this instrument . After applying forward contract, an adverse movement is protected. Secondly, an exact cost of product can be forecasted because an exchange rate is fixed in advance. This makes companies budget their fund effectively and appropriately.
However, one disadvantage does exist. Making a faulty decision, organizations might be confronted this problem. Once this instrument is generated, companies are forced to follow by fixed exchange rate. Therefore, even if an exchange rate movement is positive, firms cannot achieve this benefit regarding to fixed exchange rate in the contract. Phillips’s figure (1995) illustrates percentage of success in hedging, classified by business activities (Table 2). As can be seen, using a hedging instrument seems to provide benefits rather than drawbacks.
These successful figures are over or equal 75% of each transaction while unsuccessful data are less than 10%. It is well established that this hedging provides more positive result. This circumstance appears to suggest that an exchange rate trend is downward – country currency will be less value, a forward contract is the first option to be chosen to protect this risk. In the final analysis, it seems to suggest that currency forward contracts need to play a formal role in multinational companies.
Plus a currency forward contract is the most recommended instruments to hedge currency movement. Because exchange rate, currency and date are predetermined as acceptable condition. According to unlimited condition of forward contracts, this makes currency forward contracts are preferable to other counterparts. After applying, a currency risk will be controlled at acceptable levels. In addition, it is necessary that companies should predict exchange rates carefully therefore this instrument will be utilized efficiently.