Explain what is a hedging arrangement and how does it reduce foreign currency risk exposure

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Question: Explain what is a hedging arrangement and how does it reduce foreign currency risk exposure?

Often it has been observed that the companies are indulged in foreign currency transactions for their foreign business operations. In this process, the firms generally owe to or owed by the entities in terms of foreign currencies and due to this the entities are exposed to the risk of potential losses. This risk of loss generally occurs due to the changes or movements in the exchange rates. In this regard, it has been identified that to minimise the underlying risk with foreign currency monetary items an organisation or entity performs a hedging arrangement in its financial decision-making and accounting process (from lecture slide 25). In general, there are three types of hedges that can be identified- those are fair value hedges, cash flow hedges and hedges of net investments of foreign operations. Thus, it can be elaborated as actions undertaken either by entering into a contract of foreign currency or otherwise with a specific objective of mitigation or avoidance of potential adverse financial effects of the movements in rates of exchange.

In case of hedging, the gains or losses acquired from foreign exchange on one transaction generally require to be offset by the gains or losses on another transaction. For example, in case a fall in exchange rate occurs, a gain generally made on the sale made to the overseas purchases but a loss occurs on the contract made with the bank. This is because the value of the overseas currency increases and on the contrary the entity had already provided consent to a forward rate with the bank. However, with the increase in the exchange rate for the similar situation an opposite situation can be observed. Through the implementation of the perfectly hedged agreement the entities can eliminate or minimize the adverse impact of the changes or fluctuations of the exchange rate on the financial condition of the firm in a complete manner (Hecht, 2019). Thus, through the implication of the hedging arrangement the companies generally invest in opposite financial or hedging instruments that counter the exposure of foreign currency risk.

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