Hedging strategy
Symbolically, transaction risk is usually hedged tactically (selectively) or strategically to maintain cash flow and surplus. This hedging depends on the financial point of view of the enterprise on the future changes of the foreign currency exchange rate involved. Most enterprises use tactical hedging to hedge foreign exchange risks related to short-term accounts receivable and payable transactions, while strategic hedging is prepared for long-term transactions. However, some enterprises decide to adopt passive hedging, which involves maintaining a certain hedging structure and implementing it in a regular hedging cycle, regardless of foreign exchange expectations, that is, enterprises are not required to adopt foreign exchange rates.
Foreign currency translation risk, or balance sheet risk, is often hedged rather than systematic, often to avoid the impact of sudden foreign currency exchange rate shocks on net assets. This kind of risk mainly involves the long-term exposure of foreign capital, such as the value evaluation of enterprise subsidiaries, their debt structure and international investment. However, the long-term nature of these projects and the fact that foreign currency translation affects the balance sheet rather than the income statement of the enterprise make the hedging of foreign currency translation risk less valued in management. For the foreign currency translation of foreign currency exchange rate risk of subsidiaries, the standard practice is to hedge the balance sheet of net assets, that is, the net assets (total assets MINUS liabilities) of subsidiaries that may be affected by adverse exchange rate changes.
Within the framework of hedging exchange rate risk in the comprehensive balance sheet, the debt distribution of hedging enterprises is also the most important issue (Marrison, 2002; Jolian and Huli, 1996). The currency composition and maturity composition of corporate debt determine the sensitivity of its net assets and profits to exchange rate changes. In order to reduce the influence of exchange rate on profit fluctuation, enterprises can design the optimal hedging strategy by using the optimization model to manage their own foreign currency exchange rate risk. After the debt composition is optimized, it is an arduous task to hedge the remaining exchange rate risk exposure. Besides optimization, enterprises can also adopt tactical hedging to reduce the residual exchange rate risk. Moreover, if the exchange rate does not change in the expected direction, the hedging of foreign exchange translation risk may cause fluctuations in cash flow or profits.