Currency Hedging in Emerging Markets: Managing Cash Flow Exposure


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Hedging

Hedging is defined here as the trading of risks conducted in the financial markets. Companies do not want market-wide risk considerations that they cannot control to interfere with their commercial activities. Therefore, they are willing to trade the risks that arise from their daily trading behaviour.

Whether in industrial, commercial or financial business, the financial assets they trade (loans, bonds, stocks, equities, derivatives) allow them to hedge the risks accumulating on their balance sheets as the business progresses. From the perspective of companies and other companies trading these risks, it has also been at the heart of financial developments.

Currency Hedging

Currency hedging is entering into a financial contract for the purpose of hedging against unexpected, anticipated or expected changes in exchange rates.

Financial investors and companies use currency hedging to eliminate the risks they face when doing international business. The coverage can be compared to an insurance policy that limits the effects of exchange rate risk.

Coverage can be obtained by purchasing or booking different types of contracts designed to achieve specific goals. These targets are based on the level of risk the client is exposed to and seeking protection, and then allow them to set future interest rates without severely impacting their liquidity.

Hedging can be a very complicated endeavour. The various security mechanisms range from simple to extremely complex. The most prudent first steps in considering a hedging strategy would be to take note of potential currency risks and, based on that, assess what goals should be set and what actions should be taken to mitigate that risk.

Emerging markets

An emerging market economy is the economy of a developing country that becomes more involved in global markets as it grows. Emerging economies are defined as countries that have some, but not all, of the characteristics of a developed market.

As an emerging market economy develops, it typically becomes more integrated into the global economy, as evidenced by increased liquidity in local debt and stock markets, increased volume of trade and foreign direct investment, and the national development of modern financial and regulatory institutions. Notable emerging markets currently include India, Mexico, Russia, Pakistan, Saudi Arabia, China and Brazil.

Crucially, an emerging market economy is moving from a low-income, less developed, often pre-industrial economy to a modern industrial economy with higher living standards.

Managing Cash Flow Exposure

The use of foreign currency in trade and finance is widespread in Emerging Market Countries (EMEs). Foreign currency dominance can pose a significant source of risk related to currency mismatches in cash flows and balance sheets, leaving countries vulnerable to shifts in market sentiment, sudden stops and currency shifts or crises.

Foreign exchange derivative contracts allow companies to hedge against currency risk. Importantly, the forex derivatives market, one of the largest markets in the world, has experienced impressive growth over the past few decades, outperforming spot trading in both advanced and emerging economies. However, their growth in emerging markets has received less attention and little is known about the use of currency derivatives by companies in these economies.

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