Risk management
Risk types and hedging
Risk management identifies, measures and controls exposures. Business risk affects operations; financial risk arises from gearing, interest rates, currency and liquidity. Systematic risk is market-wide and not diversifiable; unsystematic risk can be diversified. Internal techniques include netting, matching, leading and lagging, and invoicing in home currency. External hedges include forwards, money-market hedges, futures, options and swaps. A forward locks in a future exchange rate but is binding and may require collateral. Futures are standardised and marked to market; options give the right but not obligation to trade at a strike price, costing a premium. Interest-rate swaps exchange fixed and floating payments.
Traps and rule of thumb
Traps: confusing the direction of a futures hedge; ignoring basis risk; assuming a forward is a forecast; forgetting option premiums; using the wrong interest rate in a money-market hedge. For a foreign-currency receipt, a forward hedge sells foreign currency forward; for a payment, buy foreign currency forward.
Worked example: a UK company expects $1m in three months. The three-month forward rate is $1.30 per pound. It sells $1m forward, locking in 769,231 pounds before costs. If the spot rate later is $1.25 per pound, the forward has protected against a weaker dollar. Rule of thumb: hedge only genuine exposures, match the hedge size and maturity to the exposure, and compare forward, money-market, futures and option outcomes after costs.