Question

Identifying the way in which a business is exposed to foreign exchange rate changes is half the battle in dealing with its exposure. Applying the appropriate foreign exchange risk management techniques is the other half. Discuss.

Answer 1

Businesses are primarily exposed those three types of foreign exchange risks viz., Transaction , economic and translation expsoure. Transaction exposures arises from previously entered into agreements and obligations and the exchange rate volatility affects the future cash flows. Economic exposure is when the firm's earning potential is affected due to foreign exchange risk. While translation exposure is when the foreign financial statements have to be restated in the home country's currency. Due to increasing cross border transactions and globalization the need to manage foreign exchange exposure risk is difficult than ever before. The major difficulty lies in anticipating the risks that can occur in the future since it is not limited to economic factors such as demand and supply of the currency. There are a gamut of risks involved in foreign exchange which include global geopolitics, expectations of future interest rates, inflation among others. These factors are certainly not easy to predict and require high level of precision when opting to protect against the risk. Also , another important point is that not all foreign exchange risks require to be protected against and the company may end up making more profits if left unprotected. The choice of the right techniques largely involve choice among methods such as hedging, future and forward contracts. Companies have to analyze if the transaction does require any hedging or a future contract based on their degree of risk aversion. The industry that the company operates and its margins also influence the strategy. A business that has smaller profits it is utmost important that it has a hedging strategy in place. The companies should primarily focus on minimizing risk than speculation of foreign currencies which will help them choose the right technique.