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Corporate Finance and Derivatives

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Market risks arise because of the exposure to market variables (Prasanna Chandra, 2008). Risk management is the umbrella term used to define the process that includes identification, assessment, prioritization, and management of risks in such a way so as to minimize or eliminate, if possible, the adverse impacts of the risks (I.M.Pandey, 2006). A multi-national corporation operating in different countries of the world is exposed to foreign exchange risk. The multi-national corporation receives and makes payments in different currencies of the world. Transaction risks arise because of the possible gain or loss of existing foreign currency denominated transactions (Boumlouka, Makrem (2009)). Take an example of firm A. Firm A, headquartered in the US, exports electronic goods to a firm B in the UK. The importer, B, in the UK pays the US firm in British pounds. The exporter can manage this foreign exchange risk by using derivatives. He can enter into a three-month foreign currency forward contract where he goes into the contract of selling £ 250,000 at the exchange rate of £ 1 = $ 1.57 at the end of three months when he expects to receive the payments from the exports. The forward contract will eliminate the downside risk of the foreign exchange fluctuations, but it will also eliminate the upside potential. Suppose at the time of receiving the payments, the GBP appreciates against the dollar. Let’s say that the foreign exchange rate is £ 1 = $ 1.67 then. So an alternative course of action, that the exporter may choose, is to buy foreign currency options instead of entering into forwarding contracts. The forward contracts place an obligation on the contractual parties. Options do not place any such obligation. The exporter can buy a put option to sell the pounds at the exchange rate of £ 1 = $ 1.57. He will exercise this put option at the time of receiving the payments if the exchange rate goes below GBP 1/ $ 1.57.