Question

Evaluate the extent to which a firm’s operating exposure can be hedged. (35 MARKS for this question)

Answer 1

Operating exposure of a firm is the measure of changes in its present value that results from the changes in future operating cash flows that arises from unexpected changes in exchange rates.

Now a firm can hedge its operating exposure to a significant effect. Firms can make use of contractual hedges to hedge their operating exposure. Firms can also make use of long-term currency option positions hedge and these hedges can offset lost earnings that accrues to a firm due to exchange rate changes that are adverse in nature.

It should be noted that while firms can hedge their operating exposure to a significant effect they cannot hedge all of their operating exposure. This is because operating exposure is largely a subjective concept and depends on estimates of future cash flow changes over a time horizon that tends to arbitrary. Hence the capacity to hedge a firm’s operating exposure is determined by and constrained by predictability of future cash flows of the firm.