Hedging and Risk What advice would you give regarding hedging investment? The company is building a manufacturing plant, and as such will be subject to a number of risks associated with doing business aboard. The company will face foreign exchange risk. When hedging depends on the nature of the assets it is hedging: Real assets in the foreign country, such as the plant, machinery and real estate need not be hedged since they will rise in value along with local assets. Financial assets, such as the cash flow from the operations, if it is being brought back to it’s the mother Co., do need to be hedged. There is a risk that cash flows that are due out of foreign Co. may be worth less than expected if the exchange rate weakens against the Domestic Currency. If the company had borrowed to make this investment, there is a danger that the translated cash flows may not be sufficient to service the debt, if the Foreign Currency were to weaken. So the financial assets need to be hedged, to protect their value. The company can use:  Forward Rate Agreements (FRA)  Futures contracts  Swaps  Options. The first three are similar, but options are quite different.    FRAs involve the company setting the price now for delivery at some point in the future of an amount of currency. There is no cash flow to set the contract up, only a cash flow at expiry when the contract will be closed out at the agreed rate. If the currency moves up or down, the company is protected as they have fixed the exchange rate for that date in the future. Any potential gains are sacrificed, but the company is covered against losses. Futures are similar in that they fix a rate that you are willing to exchange at in the future. With futures, however, there may be intervening cash flows, as the contracts are exchange traded (FRAs are over-the-counter instruments) and a margin may have to be paid in to cover losses. Currency swaps are like long term forward contracts. These allow the company to effectiv

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