Hedging & Positioning George Brown

Risk can be reduced as well by setting the pricing strategy based on the forward market prices. The forward market is an accurate representation of where the market thinks a currency will go, based theoretically on perfect information. Therefore, this is a better method of pricing that using the spot market.

Another way to hedge foreign exchange risk is to share the risk between the two parties. This can be done via any number of contractual structures. Brown could have taken one payment in dollars, the other in marks; or he could have asked that the payments be adjusted to reflect movements in the currency. Leading and lagging can also be used to manage the firms cash flow between currencies.

However, this would have been inappropriate for Brown, whose exposure was a single transaction.

A company could also engage in a currency swap. In this situation, an agreement would be made with another company or with a bank to trade exposures. Brown, for example, could have made a swap with a German company that had U.S. dollar exposure. Currency swaps are not likely to be perfect hedges, however, unless arranged with a bank.

A credit swap could also be used. This works the same way as a currency swap, but is done through banks. This relies on the underlying principle that currency.

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