An ABC guide to hedging on the futures market.
International trade has made businesses highly vulnerable to fluctuations in currency exchange rates. We have seen this vulnerability especially during the past 20 years, following the breakdown of the Bretton Woods agreement. Foreign exchange markets have since been characterised by pronounced instability and fluctuations in exchange rates, sometimes even on a daily basis.
In some African countries, the problem has been so bad that Ghana's opposition leader, J.A. Kuffour, thinks something has to be done: "The cedi [Ghana's currency] in our pockets loses its value on a daily basis. Each day, the cedi buys less than it did the day before. Our business people are faced with horrendous exchange rate losses that threaten to wipe them out and create more unemployment"(see NA Jul/Aug).
In April 1983, before Ghana implemented the IMF recovery programmes, the cedi exchanged for G5 to [pound]1, but by August this year it had collapsed to C9,820 to [pound]1. These fluctuations in exchange rate complicate short-term financial (and even long-term strategic) decisions. They have also imposed substantial resource costs on companies.
In its, simplest sense, foreign exchange means the number of units of one currency which may be bought or sold for one unit of another currency. In other words, iris the price of one currency relative to another currency. Foreign exchange risk is, therefore, the risk of loss (or gain) from unforeseen changes in exchange rates.
Alternative instruments can be used to reduce or eliminate this exposure. These techniques include forward market hedge, futures hedge, money market hedge, currency options, exposure netting and the use of official export/financing agencies.
The support of African governments would be needed if these instruments are to work effectively. African businesses should be allowed to open foreign exchange accounts in their respective countries or abroad without any restrictions. They may then use one or more of the following financial instruments to reduce or eliminate heir foreign exchange risk:
Forward market hedge.
This comes with a forward foreign exchange contract, which is an agreement, entered into today, to purchase or sell a fixed quantity of foreign exchange sea fixed future date.
This contract is tailor-made to meet the requirements of two counterparties in terms of size and delivery date. It cannot be cancelled without the agreement of both parties...