Question

How should managers be held accountable for foreign exchange risk if they hold a static budget? Which strategies would you use to hedge against foreign exchange risk exposure? Why might you choose these strategies in lieu of others?

Answer 1

Static budget is budget that does not change even with significant changes in volume. Static budgets do not adjust for volume effects. This as a result, forces the managers to be responsible for volume changes. Hence, managers are not prepared to afford any changes in foreign exchange in this scenario.

Assuming role of manager, I would use various financial instruments available such as natural hedge and derivates. Natural hedge is the opposite position against the beneficial direction of foreign exchange using borrowing or lending. This would reduce the exposure risk and one would cancel the movement of other if that happens reducing the loss. These hedges work by matching sales and production in same country, borrowing in currency of operation. Matching currency for borrowing and adjusting payment in that currency for payment.

On the other hand, derivatives are the contracts specifying certain conditions between two parties. The various derivates are forward contracts of foreign currency, foreign currency options, foreign currency futures and foreign currency swaps. These two methods are useful to hedge against the fluctuation risk of foreign currency.