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Hedging Currency Risk by Using Derivatives vs Gold Dinar

Hedging Currency Risk by Using Derivatives vs Gold Dinar

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Published by: profinvest786 on Jul 30, 2010
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12/25/2012

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Hedging Foreign Exchange Risk with Forwards, Futures,Options and the Gold Dinar: A Comparison Note
 Ahamed Kameel Mydin Meera
Department of Business AdministrationInternational Islamic University Malaysia
Introduction
The 1997 East Asian currency crisis made apparent how vulnerable currencies can be.The speculative attacks on the Ringgit almost devastated the economy if not for thequick and bold counter actions taken by the Malaysian government, particularly inchecking the offshore Ringgit transactions. It also became apparent the need for firmsto manage foreign exchange risk. Many individuals, firms and businesses foundthemselves helpless in the wake of drastic exchange rate movements. Malaysia beingamong the most open countries in the world in terms of international trade reflects thedegree of Malaysia’s exposure to foreign exchange risk 
1
. Foreign exchange risk refers to the risk faced due to fluctuating exchange rates. For example, a Malaysiantrader who exports palm oil to India for future payments in Rupees is faced with therisk of Rupees depreciating against the Ringgit when the payment is made. This is because if Rupee depreciates, a lesser amount of Ringgit will be received when theRupees are exchanged for Ringgit. Therefore, what originally seemed a profitableventure could turn out to be a loss due to exchange rate fluctuations. Such risks arequite common in international trade and finance. A significant number of international investment, trade and finance dealings are shelved due to theunwillingness of parties concerned to bear foreign exchange risk. Hence it isimperative for businesses to manage this foreign exchange risk so that they mayconcentrate on what they are good at and eliminate or minimize a risk that is not their trade. Elsewhere traditionally, the forward rates, currency futures and options have been used for this purpose. The futures and options markets are also known as
derivative
markets. However, in many nations including Malaysia futures andoptions on currencies are not available. The Malaysian Derivatives Exchange(MDEX) makes available a number of derivative instruments Kuala Lumpur Composite Index Futures, Index Options, Crude Palm Oil Futures and KLIBOR 
 
 
2(interest rate) Futures – but not Ringgit futures or options. Even in countries wheresuch derivative markets exist however, not all derivatives on all currencies are traded.In the Philadelphia Stock Exchange in the United States for example, derivatives areavailable only on select major world currencies. While the existence of these marketsassists in risk management, speculation and arbitrage also thrive in them, both in thespot and derivative markets. This article compares and contrasts the use of derivatives – forwards, futures and options – and the
gold dinar
for hedging foreign exchangerisk. It argues how a gold dinar system is likely to introduce efficiency into themarket while reducing the cost of hedging foreign exchange risk, compared with theuse of the derivatives.
Hedging with Forwards
Hedging refers to managing risk to an extent that makes it bearable. In internationaltrade and dealings foreign exchange play an important role. Fluctuations in theforeign exchange rate can have significant impact on business decisions andoutcomes. Many international trade and business dealings are shelved or becomeunworthy due to significant exchange rate risk embedded in them. Historically, theforemost instrument used for exchange rate risk management is the forward contract.Forward contracts are customized agreements between two parties to fix the exchangerate for a future transaction. This simple arrangement would easily eliminateexchange rate risk, but it has some shortcomings, particularly getting a counter partywho would agree to fix the future rate for the amount and time period in question maynot be easy. In Malaysia many businesses are not even aware that some banks do provide forward rate arrangements as a service to their customers. By entering into aforward rate agreement with a bank, the businessman simply transfers the risk to the bank, which will now have to bear this risk. Of course the bank in turn may have todo some kind of arrangement to manage this risk. Forward contracts are somewhatless familiar, probably because there exists no formal trading facilities, building or even regulating body.
1
The Economist magazine’s
 Pocket World in Figures
(2002 Edition) ranks Malaysia the second mosttrade dependent country in the world. Trade as a percentage of GDP is 92 percent for Malaysia, evenhigher than that for Singapore, which ranks third with a percentage of 78.8 percent. See page 32.
 
 
3
 An Example of Hedging Using Forward Agreement
Assume that a Malaysian construction company, Bumiways just won a contract to build a stretch of road in India. The contract is signed for 10,000,000 Rupees andwould be paid for after the completion of the work. This amount is consistent withBumiways minimum revenue of RM1,000,000 at the exchange rate of RM0.10 per Rupee. However, since the exchange rate could fluctuate and end with a possible
depreciation
of Rupees, Bumiways enters into a forward agreement with First StateBank of India to fix the exchange rate at RM0.10 per Rupee. The forward contract isa
legal agreement
, and therefore constitutes an
obligation
on both sides. The FirstState Bank may have to find a counter party for this transaction – either a party whowants to hedge against the
appreciation
of 10,000,000 Rupees expiring at the sametime or a party that wishes to speculate on an upward trend in Rupees. If the bank itself plays the counter party, then the risk would be borne by the bank itself. Theexistence of 
speculators
may be necessary to play the counter party position. Byentering into a forward contract Bumiways is guaranteed of an exchange rate of RM0.10 per Rupee in the future irrespective of what happens to the spot Rupeeexchange rate. If Rupee were to actually depreciate, Bumiways would be protected.However, if it were to appreciate, then Bumiways would have to
forego thisfavourable movement
and hence bear some implied losses. Even though thisfavourable movement is still a potential loss, Bumiways proceeds with the hedgingsince it knows an exchange rate of RM0.10 per Rupee is consistent with a profitableventure.
Hedging with Futures
 Noting the shortcomings of the forward market, particularly the need and thedifficulty in finding a counter party, the futures market came into existence. Thefutures market basically solves some of the shortcomings of the forward market. Acurrency futures contract is an agreement between two parties – a buyer and a seller – to buy or sell a particular currency at a future date, at a particular exchange rate that isfixed or agreed upon today. This sounds a lot like the forward contract. In fact thefutures contract is similar to the forward contract but is much more liquid. It is liquid because it is traded in an organized exchange– the futures market (just like the stock market). Futures contracts are standardized contracts and thus are bought and sold

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