There are as many different approaches to exposure management as there are firms and no real consensus exists regarding the best approach Discuss the following theoretical dimensions to currency hedging: optimal hedge ratio, hedge symmetry, hedge effectiveness and hedge timing.
What will be an ideal response?
The objective of currency hedging is to minimize the change in the value of the exposed asset or cash flow from a change in exchange rates. Hedging is accomplished by combining the exposed asset with a hedge asset to create a two-asset portfolio in which the two assets react in relatively equal but opposite directions to an exchange rate change. If the entire exposure was covered, that is a hedge ratio of 1.0 or 100%. The hedge ratio, ?, is the percentage of an individual exposure's nominal amount covered by a financial instrument such as a forward contract or currency option.
Some hedges can be constructed to result in no change in value to any and all exchange rate changes. The hedge is constructed so that whatever spot value is lost (or gained) as a result of adverse (or favorable) exchange rate movements (? Spot), that value is replaced by an equal but opposite change in the value of the hedge asset, (? Hedge). The 100% forward contract cover is symmetrical hedge.
The effectiveness of a hedge is determined to what degree the change in spot asset's value is correlated with the equal but opposite change in the hedge asset's value to a change in the underlying spot exchange rate. The less than perfect correlation is termed basis risk.
The hedger must also determine the timing of the hedge objective. The hedger can protect the value of the exposed asset only at the time of its maturity or settlement, or at various points in time over the life of the exposure.
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