Question

Many MNEs have established rigid transaction exposure risk management policies which mandate proportional hedging (a percentage of existing transaction exposures). Explain the pros and cons of proportional hedging.

Answer 1

Proportional hedging refers to the use of forward contract hedges on a percentage of existing transaction exposures. With an increase in the maturity of the exposure, the percentage of forward cover reduces. The advantages of proportion hedging is that the company can choose to hedge the exposures as per their risk appetite and maturity of the transactions rather than hedging all expsoures. Hedges can be selected based on the firms risk tolerance, estimation of the exchange rates and the confidence level. The major disadvantage of this model is that it is essentially a speculation against the currency markets. It is inherently not possible for a financial manager to accurately predict the exchange rate movements and hence the company can suffer a loss in case of adverse market conditions.