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The swap or Option Hedging Method is a type of derivative security the parties involved come in an agreement to exchange financial assets over a certain period. Swaps are agreements that involve two corporations. The parties share currency initially, and then they trade, and after making a huge profit, they share back some small amount of the profit. Later the initial amount is given back to the company that they exchanged the currencies with (Kane, 2018).
This method is usually used by companies that operate internationally and have sizeable or enough financial security. The contract involves the exchange of currency over a specific period with specific dates and times (Clark and Judge, 2017.p.382). Swaps are very important when companies decide to expand their operations to a new country and environment. For example, when the company of Virgin Australia Holdings LTD decided to extend its operations to China, the founder - Richard Branson decided to agree with China to start its operation. |Because they needed the Chinese million yuan to invest in China, they had to exchange some million dollars with Chinese million yuan with the contract having a specified time. Thus they exchanged millions of dollars for millions of yuan at a fixed rate. After the period of the contract, they returned the Chinese yuan and received back the exact amount of the dollars they invested, hence making no loss meaning the exchange rate holds no risk at all.
This method of currency trade does not follow a predefined pricing model because it is tailored contracts. The market is the one that the exchange rate of the two corporations that are involved in the trade (Abor et al.,2019, p.140). After that, they come together to decide the interest rates determined with the price of the currency at that time, as stated by the local banks. The exchange rate is retained until the completion of the agreed time duration of the contract.
However, sometimes the parties might decide on a different interest rate. Both corporations could decide to use floating interest rates, they might also agree to both use fixed interest rates, or at another instance, one party might decide to receive its interest using a floating interest rate. In contrast, the other uses the fixed interest rates.
Additionally, from our example, in a case where the Chinese bank decides to pay a 5% annual interest following the domestic deposits, while Australian bank decides to pay 1.8%. This, therefore, means that for every year, three million yuan will be paid regarding the 5% annually of the 67million and 170,000 dollars is received back from the exchange following the 1.8% annually of the 11 million invested (Elizabeth, 2019).
Abor, J.Y., Gyeke-Dako, A., Fiador, V.O., Agbloyor, E.K., Amidu, M., and Mensah, L., 2019. Asset-Liability Management: Using Hedging Techniques. In Money and Banking in Africa (pp. 135-147).Springer, Cham.
Clark, E., and Judge, A., 2017. Foreign currency derivatives versus foreign currency debt and the hedging premium. Evaluating Country Risks for International Investments, pp.381-433.
Elizabeth B. (2019) Australia group - Annual report
Kane, D.R., 2018. Principles of international finance. Routledge.
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