Foreign-currency gains and losses can also result from the uses of various currency
contracts, such as forwards, futures, options, and Swaps entered into for both hedging
and speculation. The use of various hedging procedures, is the more common method
employed to manage the risk of foreign-currency exposure.
In addition to changing exchange rates, other factors like transfer pricing and inflation
must be considered in evaluating financial performance of a foreign subsidiary and its
management.
Derivatives are powerful tools serving as basic building blocks for financial
management to shed risk, but they can also be used to take on risk or transfer risk.
Nevertheless, just as derivatives facilitate risk management, they facilitate greed and
speculation.
Managing foreign currency exposure risk can be either by compensation or by various
hedging procedures. Offsetting exposure positions may be created because of internal
arrangements offsetting balances created through normal operational activities- natural
hedges or they may entail specialized external transactions with financial firms or
markets – semi-natural hedges.
Matching the cash flows associated with foreign currency payables and receivables by
speeding up or slowing down their payment or receipt- hedging and lagging method.
Differences in hedging practices are due to different attitudes towards bearing currency
risk as well as the cost and capacity to hedge exposures in different countries.
With the option contract, cost of acquiring is termed option premium and call option
(i.e. right to acquire) reflects liability exposure whilst a put option (i.e. right to sell)
reflects asset exposure. Option values are estimated using methodologies such as the
widely used Black-Scholes option- pricing model.
Holding a derivative contract for other than, hedging purposes is normally termed
speculation. Risk management requires strong analytical background on methodologies
that can facilitates substantial judgement as to avoid risk or shield it; control and