Hedging Currency Risks at XYZ Corporation Using Derivative Strategies

XYZ Corporation, a multinational firm, primarily operates in the manufacturing sector and has significant exposure to foreign currency risk due to its operations in Europe, Asia, and North America. The company generates revenues in euros and Japanese yen but reports its financial performance in US dollars. As of the current fiscal period, the firm has determined that it faces substantial risks from unfavorable foreign currency fluctuations that could significantly impact its cash flows, profitability, and overall valuation.

As the Chief Financial Officer (CFO) of XYZ Corporation, you must develop a comprehensive hedging strategy to mitigate these currency risks. Your discussion should encompass the following:

• An analysis of the specific currency risks faced by XYZ Corporation.
• A recommendation on the appropriate hedging instruments (such as forward contracts, options, or swaps) to implement a hedging strategy that would effectively minimize these risks.
• A justification for your choice of instruments considering factors such as cost, flexibility, and market conditions.
• An evaluation of the potential limitations and drawbacks of the chosen hedging strategy.

Your response should demonstrate a deep understanding of derivative strategies and currency management. Provide clear, structured, and well-supported arguments to justify your recommendations.