Question

Explain how hedging may create value for a firm. How would a treasure determine whether or not to hedge, as well as the correct strategy to hedge FX risks

Answer 1

Hedging is a technique used by the Financial Managers to minimise the Foreign Currency exposures i.e. Foreign Currency payables and Foreign Currency receivables. It adjusts with the fluctuations of Foreign Currency. The main idea with hedging is that it should minimize risk and even increase the firm value. Hedging increases a firm's value by reducing expected taxes and expected costs of financial distress. If a company doesn't hedge it's Revenue is impacted because of the international sales.

Now, To hedge or not to hedge - everything depends on the firms’ understanding and tolerance of foreign currency risk. There is no single right answer to the question of whether to hedge or not to hedge. Sometimes, Hedging is not used because of these reasons:  they might not know the risk exists, they know it exists but think it is trivial, they perceive that it costs too much, they think that any fall in the value of the currency will eventually be reversed while the Conservative firm will always hedge.

There are many instruments in the market to hedge the currency risks such as currency swaps, forward contracts and options. Hedging techniques depends on the nature of transaction you are going to enter in foreign currency like, the most common hedging tool, forward contracts, fix a defined future date at which to buy or sell a stated amount of currency at an agreed rate when you have a fixed date of payment of foreign currency or when you have fixed date to receive the foreign currency.

NOTE: The answer to your question has been given below/above. If there is any query regarding the answer, please ask in the comment section. If you find the answer helpful, do upvote. Help us help you.