How Do Currency Derivative Instruments Function as Hedging Mechanisms for Multinational Firms Operating in High Volatility Forex Environments, And to What Extent Do They Transfer Versus Redistribute Exchange Rate Risk Within the Financial System?
Abstract
As a result of globalization and growing international trade, MNCs are increasingly exposed to forex risks (foreign exchange rate risk) due to the fluctuation of currency values. In countries with significant forex market volatility, uncertainty regarding exchange rates has a significant impact on an organization’s profit, cash flow, investment decision, and overall stability of its finances. To mitigate currency exposure and risk, MNCs have adopted the use of derivatives (in particular, currency derivatives) as means to hedge against foreign exchange risks. This study aims to analyze how currency derivatives operate as tools to eliminate or reduce risk associated with exposure to foreign exchange rates and determine if currency derivatives reduce or redistribute risk within the global financial system. The research methodology for this study is based on analysing existing literature and secondary data, followed by an analytical discussion of hedging strategies used by corporations, currency derivative market behaviour, and systemic risk associated with finance. The research indicates customers using currency derivatives can better manage the predictability of cash flow, reduce the risk of earnings volatility, improve financial forecasting/financial planning and be protected against currency fluctuations when making foreign investments. However, the study also states that customers essentially transfer their financial risk to derivative dealers and financial institutions increasing systemic risk or potential for systemic risk during a financial crisis. Therefore, the research concludes that regulated, transparent, and effective risk management/hedging frameworks will enhance stability in what has become increasingly globalized, volatile, and interconnected forex markets.