Hedging of a multinational firm using futures and options that is subject to price uncertainty due to foreign exchange fluctuations

Abstract

After the switch to floating exchange rates in 1973, internationally active companies became exposed to interest and foreign exchange risks. In this thesis, the hedging alternatives due. to foreign currency risk and devaluation are analyzed for a multinational firm whose liabilities from import activity is fixed in terms of foreign currency, but the corresponding domestic price is uncertain. As the main alternative ' fiitures and options ' are examined. Firstly, the related literature is investigated, the required information is given, and the case study is introduced. Under three different scenarios, the possible changes in foreign exchange rates are given. In the first scenario; the possibility of dollar's gaining value, in the second scenario; the possibility of the cross' being the same at expiry, and in the last scenario the possibility of dollar’s loosing value in foreign market are considered. Since the aim is to hedge the potential losses due to changes in cross rates, the company's position is carried in a % 50 US dollar % 50 Deutsche mark basket. This position is analyzed according to the three different scenarios and the profit / loss realized under the alternative hedging strategies are demonstrated. The alternative hedging methods are no hedging, forward with cross, forward with domestic currency unit, and options on futures. It is shown that the alternatives provide perfect hedge but, since the application of the different strategies involves advantages and disadvantages depending on the particular scenario, the decision on which strategy or combination of strategies to use has to be made on the merits of each individual situation.