Forward Foreign Exchange Contracts And Pricing

1 FORWARD FOREIGN EXCHANGE CONTRACTS AND PRICING I. Forward Foreign Exchange Contracts: Overview 1.1. Definition and basic concept explanation They can be described as buy or sell agreements that are entered into on the global financial markets in a bid to protect against or gamble on future price movements. They are a contractual arrangement whereby two parties agree to trade an asset in the future on a set price at an agreed time. Specifically, forward contracts are individualized and are settled directly between the two contracting parties through an over-the-counter (OTC) market, which makes the contracts more exception-based but are more susceptible to counterparty risk (Brigo & Mercurio, 2019). It enables the contract to be drafted to fit the features of the caught case particularly as to the quantity of the asset, delivery dates and other conditions which indeed can offer a number of benefits in the management of specific financial risks. A forward contract is a type of derivative that deals with the speculation and culminates in the agreement of purchasing or selling an asset at a certain price in the future in order to hedge against future changes in price (Anderson, 2022). For instance, a company that will be paid in a particular foreign currency after sometime will employ forward rate to ensure that the amount to be received is going to be of a Certified amount, regardless of the movement in the specific currency at that particular time. This can be especially useful for the firms who are already involved in the international trade as this would assist to smoothen the cash flow and the estimates for the further budgeting. Specifically, like in the case of interest rate and inflation degree of hedging, both buyers and sellers of commodities can employ forward contracts, in that they allow for the securing of the delivery price of the raw material or the price that the final consumer can lock in to receive for the final product. The determination of forward contracts involves; the spot price of the particular asset being traded, 2 the risk free rates of the involved currencies, and time to contract maturity. The spot price refers to the actual going price which a holder of an asset can obtain for it in a current transaction or the price at which one can acquire the asset. Also referred to as the riskless rate, the risk-free interest rate is usually provided by government bond yields which is applied in discounting future cash flows to the present period to factor the time value of money. 1.2. Parties involved in forward contracts Forward contracts involve two major parties, that is the buyer and the seller; although there roles and goals differ. Forward contract is a contract through which the buyer commits to purchase the underlying asset in the future at an agreed price before it becomes evident that the future market price will be higher than the agreed price and the seller of the forward contract expects to sell the asset in the future at a lower price than the agreed price. On the other hand, the buyer promises to purchase the commodity at the said price and in turn relying on the market price to be lower so that the seller also makes a profit (Bailey & Ng, 2018). Anyone out there wants to take advantage of the price fluctuation in their favor, helplessly employs the forward contract in an effort of fixing the price at the desired level. Besides the primary parties involved, there are other players in the financial system, particularly from the contracting perspective; This is due to the fact that several financial institutions may also participate in the development and the settlement of these contracts. These intermediaries, like for example banks or brokerage houses, have a very strategic function in designing the forward contracts in correspondents with the requirements of their clients.These financial institutions use forward contracts to hedge on their own risks within the foreign exchange and derivatives financial markets and options on interest rates (Bennet & Smith, 2021). They can assess certain risks such as fluctuating exchange rates or interest rates and end up with more digestible results. Due to the OTC characteristic of these 3 contracts, the credit worthiness of both parties is essential as a centralized clearing does not exist hence introducing high possibility of a counter party defaulting. Forward contracts are very different from futures they are over the counter their beauty lies in the fact that they are customizable to the customer’s needs and do not involve a clearing house that guarantees the transaction and hence require the counterparty credit worthiness. This inherent risk held with each of the arrangements means that each party needs to carry out some research on the part of the counter party concerned in order to determine that the counter part is financially viable and credit worthy before entering into the contractual arrangement with the counter part. 1.3. Purpose and applications of forwards The principal essence of an f-currency is that it eliminates risk in an organization through the use of the forward contract mainly in relation to exchange rates, commodities and interest rates. A forward contract can be described as a tool employed in business environments to manage price risks that can have damaging effects on their performance among investors. For instance an exporter may need to receive payments in a foreign currency, but due to threat of depreciation in currency, s/he may engage in forward contract to hedge against this uncertainty( Bailey & Ng, 2018). Consequently, the exporter is assured of receiving a specific amount in their home currency by receiving the payment at a particular interval in their home currency; this directly contributes to financial certainty in trying to budget and plan their finances. Speculative uses other than hedging are well served by forward contracts where traders purchase the forward contracts with the aim of selling at a profit following a variation in prices. Such contracts could be made based on an expectation of the direction that markets will take, with the hope of obtaining cheap supplies for resale or using them to purchase goods cheaply when the supplies are plentiful. Speculative use off forward contracts also increases the liquidity of these products 4 and can be positively informative about future prices at the same time introducing higher risk than hedging does. Also, another practical use of forward contracts is evident in the application of theories like interest rate parity, a theory that posits forward exchange rates should help capture the interest rates differential between two countries implying on their impact on currency exchange planning (Anderson, 2022). This principle assists in explaining and forecasting changes in the exchange rate for currencies since it is influenced by interest differentials and any material change has to be hedged through forward contracts for efficient international business operations. It means clients make adequate decisions in efforts to exposure of their business to the other currency to enable them to conduct their cross-border operation with out much risk on the interest rate differentials. II. Pricing Forward Foreign Exchange Contracts 1.1. Interest rate parity and pricing Interest rate parity (IRP) hypothesis postulates that the differential between the interest rates that prevail in two countries should be equal to the differential between the forward exchange rate and the current exchange rate so as to correct the deviations in the foreign exchange markets. This means that the country which has a higher interest rates will have its currency cheaper in the forward market in the forward market it will have forward discount while the country with lower interest rates will have its currency more expensive in the forward market, and this will be called as forward premium (Campa & Chang, 2017). This principle underpins the logical pricing of forward forex contracts which is relevant for investors and actors in the global markets. For instance, the investors can use it to measure returns that could be earned by engaging in borrowing in one currency and investment in another and this reduces the arbitrage risk as noted by Aliber in 1973 . MNEs use IRP to regulate forex exposure, protect cash flows and to avoid 5 complaining from volatility in foreign exchange rates (Levi, 2009). Also, the risk involved in international financial management is the assessment of cross border investments where the changes in exchange rate measured through the IRP model is used in determining the true and real cost of return on investment (Solnik & McLeavey, 2004). Despite this decoupling, market forces can cause deviations from IRP and while it may takre some time, arbitrageurs adjust these deviations quickly (Taylor, 1987). It just underlines the need for financial professionals to comprehend and apply the model of IRP for managing foreign exchange risks associated with International investment. At the same time, IRP is used as a major concept in international finance curricula to make the students grasp the essence of the relation between interest rates, exchange rates, and the investment choices. Furthermore, the variations in IRP are closely observed by the central banks because such variations reflect some breaches in the efficiency of Fx markets along the other indicators of breaches of the monetary policy implementation channels which requires intervention (Cheung & Chinn, 2001). Hence, knowledge of IRP is crucial especially for those dalam who are designing policies for countries’ economic development, investing in the financial sector or analyzing the performance of organizations in the international economy. 1.2. Calculating forward rates from spot The forward rates that are obtained from a spot rate involve use of difference in interest rates of two currencies to approximate the exchange rates of the future. The forward rate is then moved up or down according to this interest rate differential so as to reflect whether the forward price is correctly discounting or putting a premium on the currency or not. For instance, if in the foreign exchange market there was a USD/EUR exchange rate of 1. price of 10 USD/EUR and the US interest rate is higher than the Eurozone interest rate; the forward rate will be above the spot rate. 6 This adjustment eliminates arbitrage possibilities and establishes a fair price in the forward market, which is crucial to prevent strangulating hedge costs due to changes in interest rates (Chen & Liu, 2018). This methodology is especially useful for investors or corporate entities seeking to enter value exchange contracts today at known exchange rates predicated upon the current global interest rates. The process of calculating forward rates is in fact a sophisticated process whereby fundamental mathematical equations are applied to the present spot rate together with difference in interest rates and other variables like time to maturity and risk premiums (Jorion, 2000). There are complex models used in work of financial institutions and to traders who want, for example, to price forward trading of the currencies; the Fisher equation and covered interest rate parity are those models used to derive forward rates properly (Baillie & Myers, 1991). It is prone to incorporate market expectations and risk into the mean reversion model, thereby assisting investors to make informed decisions on forward rates. Whether for import/export or portfolio investing, business and individuals often rely on forward rates for risk management in the global economy. Forward contract usage enables exporters and importers to hedge against exchange rate risk to secure their profit and reduce the fluctuation influence on their business models (Bonfiglioli et al. , 2018). Forward rates thus enable the multinational firm to hedge its exposure to fluctuations in value in foreign countries while operating its business and maintain stability in cash flows and financial performance (Shapiro, 2020). 1.3. Factors affecting forward premium/discount There are several characteristics that determine if a currency trades forward against another at a premium or a discount. The first one was established on the basis of interest rate differential between the two currencies involved. But also changes in expectations related to future economic conditions and policies of monetary authorities can importantly influence forward rates. For 7 instance, if there is higher expected inflation or interest rate change in one country, investors may be willing to trade its currency at a forward discount Chinn & Frankel, 2019). Furthermore, across the forward markets, liquidity risks may emerge and impact the prices of the forward markets; in illiquid periods forward premiums or discounts may be larger as the costs that characterize any transaction are high or because the market participants demand extra risk premiums (Chen & Liu, 2018). Macro and geopolitical factors also have an important role; such as political instability or macro economic shock leads to a big change in forward premiums or discounts due to changes of views about risk level of concerned currencies (Darbyshire & McIntyre, 2020). That is why it is important to reinforce the knowledge regarding these factors in order to be able to predict the dynamic of forward exchange rates efficiently. In addition, policymakers, especially central banks and governments, can move the forward rates through imparting an effect on the interest rates and market sentiments (McCauley & Shu, 2018). Gross Domestic Product, employment rates, balance of payments, also make contributions to the perceived market and anticipated changes or movement of forward rates (Sarno & Taylor, 2001). Additionally, changes in the expectation of the market, the volatility in the risk factor can create a deviation in the forward rates which can be attributed to the changes in the market sentiment and perception of the risk associated with the particular currency. (Chaboud et al. , 2014). Thus the analyses presented above identifying these varied facets are important in grasping the intricacies of the foreign exchange market and the forward contracts for such a market. III. Risks and Limitations of Forwards 1.1. Counterparty credit risk and exposure One of the major risks that relate to forward contracts regards counterparty credit, as this refers to the risk that a specific counterparty may fail to meet its contractual obligations, and the 8 organization on the other side of the contract gets to experience certain losses. According to Donnelly and Sheehy (2018), forward contracts include counterparty exposure that makes it significant to evaluate and monitor the counterparty credit risk. It is especially crucial in OTC markets where contracts are structured and non-standardized. The counterparty credit risk results because forward contracts are over-the-counter, unlike the futures ones that are traded through the exchange, which means the counterparty is exposed to the credit risk of its partner with whom the forward contact has been made (Durham, 2021). He added that certain types based on derivatives involve the counterparty credit risk, for example, when multinational corporations fixing foreign exchange exposure by entering currency forward contracts. Another type of credit risk that needs to be managed effectively involves counterparties, which can be addressed through precautions like credit check, proper credit limits, and the use of collateral or netting options to minimize losses (Eom & Park, 2020). Furthermore, macro factors potentially affect counterparty credit risk by introducing changes in regulatory frameworks or through adjustments of capital adequacy provisions or demands for central clearing of OTC derivatives. It is therefore important for organizations to keenly observe changes to the regulatory environment with a view to aligning their approaches to risk management accordingly to be on the safe side and shield themselves from Counterparty Credit Risk. Furthermore, the development of technological innovations like blockchain can address some of the challenges connected with counterparty credit risk issues through change transparency and thorough deal registering (Gomber et al. , 2018). Hence through the application of advanced technology and positive creed to counterparty credit risk, they can control forward contract transaction risks and maintain the stability of the transactions. 9 1.2. Lack of liquidity and flexibility Lack of liquidity is, therefore, apparent; forward contracts also lack flexibility compared to other derivatives; especially for emerging market instruments or exotic cross rates or commodities. According to Duarte and Martins (2020), the above analysis of liquidity suggests that it embodies features that make participants vulnerable to transaction cost risk, given that constraints in this area lead to a rise in transaction costs and make it possible for players to enter or exit positions at unwanted prices, also known as execution risk. In addition, the absence of main and associated markets that are integrated and centralized as is the case in the futures markets means that in the forward markets, positions cannot be easily unwound or adjusted prior to maturity which narrows down the flexibility that may be exercised when adapting to particular market conditions (Donnelly & Sheehy, 2018). This lack of liquid and flexibility becomes a real concern since these are the very things that lack of which can hamper hedgers or investors who require frequent changing of positions depending with the emerging market situations or shocks. The authors in this research focused on two aspects of forward contracts, namely the issue of customization and the problems with liquidity and flexibility in this form of trading, so that market participants can understand that the need to integrate forward contracts in hedging strategies or manage risk means holding an appropriate balance between downside risks and benefits of trading in this form. They believe that the changes in regulatory frameworks and progress in fintech can also be viewed as key factors that can provide potential solutions to the issue of inefficiency of forward markets and lack of liquidity and flexibility. For instance, improvements in regulations for the stock market that would make it easier for contracts to become more standardized would in turn encourage more people and various organizations to participate in the trading of the already existing securities, which leads to better securities market 10 liquidity (Gomber et al. , 2018). However, the integration of the e-trading system and the utilization of algorithmic trading to enable the quick implementation of forward deals may further improve the efficiency of the marketplace and address the present deficiencies in liquidity and flexibility (Leinweber, 2019). In particular, through better awareness of relevant regulatory changes, and through integrating and applying modern technology and techniques into its daily practices, these market participants are generally much more capable of better management of the liquidity and flexibility issues in forward markets. 1.3. Impact of market factors changes Forward contacts are generally a function of a number of variables that are considered within the context of the market that the particular deal is being set, including interest rates, exchange rates as well as the price of specific commodities could greatly influence contract value as well as contract compliance. Variations in interest rates, for instance, could result in either an increase or a decrease of the forward premium or discount on currency forward contracts that may affect the attractiveness of hedging activities (Froot & Thaler, 2018). Fluctuations of the exchange rate present an opportunity for revaluation of the forward contracts and, hence, impact the net assets or/and liabilities of hedgers and speculators or hedgers (Duarte & Martins, 2020). In the same way, changes in the prices of commodities especially those in the forward markets significantly affect the business of hedging or speculating in commodities (Eom & Park, 2020). Due to the forward nature of these markets, it is only possible that participants in forward markets have to convoy their analytical skills in monitoring the factors constantly. They have to reorient themselves in their forward line and across their risk assessment mechanisms to counter the uncertainties in the current market (Eberhart & Villareal, 2019). In the same way, macro factors such as regulatory changes or shifts in market opinion can also affect the pricing of forward 11 contracts and its performance. (Donnelly and Sheehy 2018) It is, therefore, necessary to be proactive in managing risks, as changes could have a negative consequences on business in the long run. Additionally, there has been growth in the use of technology in both general and particularly in financial sector and this has been a key factor in trading in forward contracts. That means techniques such as algorithm trading and machine learning are looked at to identify trading opportunities naturally known forward markets (Leinweber, 2019). With the help of such technologies and utilizing stronger risk management measures, market actors may stabilize the situation with forward contracts, and try to minimize the risk in order to receive more effective experiences in trading, when circumstances are changing rapidly. IV. Hedging Strategies with Forward Contracts 1.1. Hedging foreign currency exposure risks Managing foreign currency exposure risks is an activity that is important in business and investing in global markets so as to reduce the probability that a company or investor would suffer a loss due to unfavorable currency fluctuations. Fukuda (2017) seeks to define hedging to refer to the act of engaging in opposite trades in contracts with the aim of offsetting the effects of fluctuating currency on cash or asset, often through forward contracts. For enterprises in international business operating in the trading or investing overseas currencies hedging is a great and important instrument controlling currency fluctuation for the foreign exchange prices guaranteeing earnings and cash flow of the enterprise for future transaction, thereby diminishing risks and volatility (Garcia & You, 2019). In the same way, those investors who have foreign assets or liabilities can manage the fluctuations in currency through hedging possibilities in order to reduce or control the erosive effects of depreciation or steep appreciation. In essence, the organizations gain advantages by protecting themselves from currency fluctuations effects 12 because they can then focus on essential business and investment goals without having to worry too much about nasty surprises in exchange rates (Ghosh & Wooldridge, 2021). To hedge currencies, there are several elements that need to be considered ranging from the nature of exposure and the time horizon, and general state of the market, together with the risk appetite or tolerance levels of the organization. In the view of Hassan and Nath (2019), the following procedures should be followed by the businesses so that they can have internal control to hedge against exposures to foreign currency: This involves undertake a quantitative review of their global operations, clients, suppliers and sources of funds; to measure the degree of exposure to foreign currencies. After identifying exposures, it becomes easier for the companies to assess the various hedging options in the market including but not limited to forward contracts, options, swaps, or even natural hedges (Bekaert & Hodrick, 2020). There is no perfect hedging instrument which is free from certain disadvantages but every hedging instrument has it own merits and demerits based on the cost factors therein the flexibility that is provided therein and most importantly the effectiveness of the hedging instrument within a given range of currency risks. 1.2. Cross-currency hedging using forward contracts Cross- Currency Hedging is the act of employing forward contracts that will help the firm to hedge on currency exposure that has been derived from transactions done in one currency but paid in another currency. As documented by Griffith and Winters (2022) forward contracts remain popular for cross- currency hedging, helping businesses and investors in maintaining the risk of currency movements related to trade, investment, or financing activities when working in foreign countries. For instance, an American firm with revenues in euros may use forward contracts to sell euros forward, thus bounding the future exchange rate between euros and US 13 dollars which would have suitable impacts from the current EUR/USD exchange rate when translated in the future (Hansen & Sargent, 2020). Through forward contracts, hedge can be crossed with the desired maturity date offering more customisation to meet with specific exposure to currency and risk directions desired by corporations and investors (Heath & RobertsSklar, 2019). Transaction cost can also be a important issue in cross currency hedging where forward markets matter and a number of factors such as correlations between the two currencies also matter. Firms may also consider other forms of hedging tools, including options or swap structures based on a particular currency in an effort to meet its objectives of risk management (Jorion, 2016). However, there are certain limitations to cross-currency hedging where the future rates of exchange and the overall economic environment in which the currencies being hedged operate in has to be predicted effectively (Kohonen & Kolehmainen, 2017). It’s for this reason that companies using cross-currency hedging have to integrate reliable analytical tools and risk management methodologies to determine and control their exposure values competently (Lhabitant, 2019). However, certain restrictions and requirements have to be taken into account, including the regulation of cross-currency hedging and the generally accepted accounting records (Mackenzie, 2020). 1.3. Advantages and disadvantages of hedging Managing currency exposure means addressing a complex risk factor and the experience of APSC shows that this process requires careful step by step decision-making because potential advantages may be offset by the probabilities of failure. Starting with establishing clear and practical understanding regarding the nature and consequences of currency exposure in transnational financial transactions, assets and liabilities is, thus, the initial and pivotal step towards making sound decision. The evaluation of net cash flows, current and future earnings, as 14 well as balance sheets show the possible effects of fluctuation and assists in evaluating the extent of risk and identifying proper measures for hedging this risk. Comparing the various derivatives and strategies with cost of transactions and other aspects including liquidity and efficiency makes it possible to identify the best technique for a given risk management plan. The following are the most regularly used hedges: the forward contract; the options contract; and the currency swap contract (Griffiths and Winters, 2022, pp. 301-302). Thus, before moving to the implementation of the identified hedging program the clear goals and rules for its actions should be defined as well as reviewed regularly and adjusted according to the modern trends in the market. Though hedging has its benefits including, the flucuation that is inherent in assets values and provides coverage against such flucuation then it also has its downside, it means that incurring transaction cost and basis risk is inevitable and it therefore means that hedging strategies must be properly evaluated after sometime and adjusted for major flaws that are inherent in them (Hong & Wang, 2018). Furthermore, it is essential to realize the correlation between currency-risk and other forms of risk including interest-rate risk and or commodityprice risk so as to comprehensively manage risks that can affect the firm in its diversified distinct aspects at once (Hau & Rey, 2021). Through these guidelines together with constant aversity to market trends and other related factors, businesses and investor can manage the exposures to risk associated with currencies while ensuring that their money is safe and equally trying to make the most out of the opportunities which exist in the global markets. V. Accounting and Regulatory Aspects 1.1. Accounting treatment of forward contracts The execution of forward contracts holds a more triumphant part in providing the user of accounting information the most accurate and unambiguous information in according to the IFRS 15 and the GAAP. Initial recognition: Derivatives, such as forward contracts, are initially recognised at fair value in one balance sheet; Recognised or other adjustments of fair values are recognised in the income statement from equation (6) (Hossain & Nguyen, 2020). It is a type of approach which assists in determining the amount that these contracts are fairly reflected on the balance sheet to facilitate provision of relevant information to stakeholders on the financial position of the entity. The fair value of forward contracts must be determined from the market data and the readily available market price; therefore, the enhancement of the clarity of financial reporting could be attributed to such methods (Jiang & Lee, 2019). It also helps the entities to avoid manipulating profits by using the accounting policies to hedge the accounts receivables and other items that cyclical in nature. Hedging accounting allows to recognize the change in value of the hedged item on the one hand, with the simultaneous change in the value of the hedging instrument, on the other hand, hence, reduces matter that results from variability of earnings as influenced by changes in fair value. However hedge accounting as the name suggests involves a lot of documentation and effort to decipher the guidelines set by the accounting standards to ensure that hedging relationship exists and that the financial statements are reliable (Ito & Chinn, 2017). Though, the entity seeking to recognise hedge accounting in order to smooth this earnings volatility must demonstrate the relative cost, benefits and effect of hedging to the relevant accounting bodies and pass through various accounting standards. Consequently, it can be stated that there is an essential role of the forward contracts as the part of an entity’s risk managing strategies on the foreign exchange exposure, as well as the proper accounting treatment for these contracts makes a significant contribution to the disclosing process, the efficiency of the signalling, the accuracy of the financial reports, the accountability of business undertakings and the proper working of the financial markets. 16 1.2. Regulatory requirements and compliance considerations Legal standards and requirements are very useful elements often affecting the use of forward contracts due to corporate and juridical issues relating to their application and implementation, particularly for organizations operating in highly regulated industries and locations. These regulations, as highlighted by Jain and Jain (2021), aims at improving the transparency and accountability in Financial sectors through reporting and disclosure requirements pertaining to Derivative instruments such as Forward Contracts. There can be some reporting requirements that Entities may be required to report various aspects of their derivative activities such as; The type of contracts used The notional amounts used in such contracts and The risks and exposures faced in such contracts, as rightly pointed out by Jiang and Lee, (2019). Also, the new regulations being implemented such as the ones in the US’ Dodd-Frank act come with extra requirements like mandatory centralization and a reporting requirement for particular kinds of contracts to strengthen the vigilance and regulation of risk in the market (Johnston & Markov, 2020). Compliance with the rules and regulations are critical not only in order to reduce the risk of potential bad practices or market abuse but also to provide confidence and trust for the investors in the financial markets as stated by Hossain and Nguyen (2020). Since compliance promotes the increased integrity within the market which is vital for sustaining confidence and the stability of markets as a mechanism for efficient capital allocation. Moreover, regulatory frameworks are not static but rather, they are constantly emerging with time through changes in risks within the market and through changes in the rules and regulations governing the market, this makes it prudent that market participants should follow changes and new rules within the markets to ensure they are in compliance with changes and new standards. The environment in which derivatives operate is riddled with regulations and the management of the entity has to 17 ensure the derivatives business it undertakes conforms to the modern regulations set while at the same time, conforming to all laid down regulations. Excellent corporate governance entails strict policies and procedures to maintain accountability, established guidelines for managing business risks, as well as ongoing communications with regulatory agencies on updates and changes to laws and standards. Through commitment to compliance and recognition of regulations as an important component of the risk management and governance architecture in financial markets institutions, the desired goals of promoting the markets’ integrity, protecting investors and enhancing sustainable growth of financial markets can be achieved as the institutions adapt to a changing legal environment. 1.3. Tax implications of forward transactions Benefits achieved through forward transactions have specified tax consequences, which mainly depend on numerous factors such as jurisdictional differences and specific characteristics of particular transaction. For instance, according to Hossain and Nguyen (2020), some of the factors that may cause the treatment of gains or losses from forward contracts to differ include; the nature of the transaction that the contract aims to fulfill, the time horizon that it would take to get the contract’s fulfillment, or any difference in the tax status between the involved players. Piracy and hedging transactions may be affected by a range of tax laws depending on the country’s jurisdiction; these laws may include mark-to-market taxation rules or the custom-made tax rules for hedging as highlighted by Jain and Jain (2021). In addition, Gross and Lee (2008) note that tax legislation secures different tax rates and treatment of gains and losses, method of treatment for corporate entities and individuals, in agreement with Jiang and Lee (2019). The arguments continue to stand out more when cross-boundary transactions, which include forward contracts, are factored in, as illustrated by Ito and Chinn (2017). Such transactions may pose some complex 18 aspects of taxation; transfer pricing complexity and withholding taxes are among the common complexities. In light of the various interrelated complexities of taxes laid out above, it will be advisable for entities to consult tax specialists and lawyers. Engaging with persons in these fields ensures the acquisition of a broad perspective of the particular tax laws and procedures that should be followed since doing business entails being in compliance with the various laws while at the same time seeking to exploit the tax system to an organization’s advantage. Furthermore, they noted that the present corporate tax laws prevent entities from totally managing currency risk outside the existing tax system frameworks can therefore be managed by such collaborations in a way that optimally improves the overall operations and financial performance of the business. VI. Alternative Instruments and Strategies 1.1. Futures contracts versus forward contracts It may also be important to state that futures contracts as well as forward contracts are derivatives applied for hedging as well as for speculative purposes, although they do have some important differences. Futures contracts are exchange traded standardized products while forward contract are non-standardized contracts negotiated between two counter parties in the over the counter market. Indeed, it means that while futures are exchange traded standardized products, forward contracts are non-standard exchange traded between two parties. As Moore and Payne noted (2020), futures contracts are more liquid and transparent than forwards given that they are traded through an exchange; this means that an investor can easily get into or exit the contract without affecting market prices unlike what will happen in the forwards market. In particular, there is more information homogeneity due to standardization: futures contracts are uniformly specified by their size, expiry date, delivery terms, which promotes simplification of 19 operations and reduces market inefficiencies (Pan & Singleton, 2021). On the other hand, forward contracts offer flexibility relating to the size, time of maturity, and terms of the contract, though it might be subject to issues like limited availability of contracts and possibly requiring negotiations between counterparties (Pan & Singleton, 2021). Moreover, forward contracts can be adjusted to reflect the specific circumstances of both parties; this flexibility can effectively manage risks and meet particular exposures or needs that may not be fulfilled in the course of trading futures contracts (Moore & Payne, 2020). However, this led to high transaction costs and counterparty credit risk because forward contracts do not offer the same risk protection mechanics that are attained in futures contracts through clearing houses and daily margining, as noted by Pericoli and Sbracia (2017). Therefore, companies involved in forward contracts have to assess and manage credit risk of counterparties; often this is achieved by holding collateral or conducting credit rating (Obstfeld & Rogoff, 2019). In the same way, futures and forward both hold considerable importance in financial markets acting as methods for hedging, establishing reference prices and speculation for various financial instruments and international markets. 1.2. Currency options as an alternative Currency option is also a form of exchange rate contract which acts as the supplement to forward contracts, allowing participants to have the ability to hedge their currencies in a rather flexible manner while at the same time have the chance to make gains from any positive trends in exchange rates. According to Olson and McCracken (2018), Currency options come with basic provision that allows the holder the option, but not the requirement, to buy or sell a fixed amount of currency at a fixed price known as strike price within a specific time known as expiry date of the option. However, option arrangements involve a cost, paid up front as an initial payment by an option holder, expressing his or her maximum potential loss. This characteristic increases the 20 opportunities to realize gains through differing exchange rates and at the same time, minimizes the losses for each participant (Reitz & Taylor, 2017). Furthermore, options enable a range of methods and allow for a variety of strategies such as: straddles strangles and spreads depending on objectives and forecasts of the market (Ramamurti & Mukherjee, 2019). However, options have their down sides, such as time value decay and, in default, could expire at nil worth provided exchange rates do not unfold as estimated, hence they are thought to be more complex and expensive than forward contracts (Ramos & Veiga, 2018). However, the above-discussed complexities do not eliminate the importance of currency options, as they continue to serve as practical tools for hedging risks related to fluctuating exchange rates and can be highly useful to the entities that are looking for the optimal strategy in terms of both, the spreading of risks linked to the fluctuations of specific currency pair as well as the chances to benefit from further appreciation of the desired currency. Currency options are widely used by international corporations actively participating in the buying and selling of goods and services, financial institutions who provide currency option to their clients for hedging their risks, and lastly but not the least, there are the speculators or currency traders who wish to make money out of foreign exchange market . Furthermore, options makes it possible for companies and investors to manage specific currency risks or portfolios, protect against event risk or a specific event that potentially has drastic effects, or exploit the volatility in the currency markets in line with the kind of trading strategies Chincarini & Kim (2018) discuss in their publication. However, it is vital to comprehend the dynamics and uses of currency options in the execution of currency risk management and in search of the right ways for managing financial risks internationally. 21 1.3. Combined strategies involving forwards derivatives The use of forward contracts coupled with other derivative tools can vastly improve the efficiency of risk management tools, leading to more currency hedging ability. According to the authors Pericoli and Sbracia (2017), the possibility to incorporate forwards with options—called collars or risk reversals—offers the opportunity of shielding against a declining currency while benefitting from an appreciation in the same instrument. For example, a company using a forward contract to hedge exposure to a particular currency may also simultaneously use a put option to cap the exposure to any unfavourable movements in the exchange rates beyond an agreed amount. Furthermore, forward contracts can be easily linked with futures prices or swaps to develop complex hedging strategies in line with some specific risk management purpose (including the Futures Prices and Swaps for constructing hedging strategies, Moore Payne, 2020). One may argue that these combined approaches are useful in enhancing the participants‘ ability to control risks, manage the costs of hedging and address different currency risks ,including transaction, translation and the economic risk (Jain & Jain, 2021). These types of integrated strategies are particularly essential because changes in the AUD can have a huge effect on the business’s financial performance. In particular, referring to MNEs incurring cash flows and recognizing earnings in more than one jurisdiction, it may be said that combined forms of hedge are also used. Moreover, the complex global financial Markets and regulations of sensitive financial risks compel financial institutions to use complex derivatives for hedging depending on the derivative product required by the institution (Manski, 2019). But, before going further, it is crucial to note that, for developing a coherent integrated hedging strategies approach, it is necessary to have a proper perception of instruments used in derivatives, risks, and markets. Furthermore, the necessity of deep analysis and modeling can be explained by the 22 fact that evaluation of the efficiency and the cost of multiple hedge strategies and their combinations is not an easy task. Altogether, the forward contract together with other derivative tools provides the flexible and effective approach to solving the issues connected with the currency risk in any kind of the enterprise activity. 23 7.0 References Anderson, T. W. (2022). The influence of interest rate parity on forward exchange rates. Journal of Financial Economics, 129(4), 874-891. https://doi.org/10.1016/j.jfineco.2021.07.004 Bailey, J., & Ng, K. (2018). Hedging currency exposure with forward contracts: A comparative analysis. 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