Foreign Exchange Risk Management

1
Foreign Exchange Risk Management

• Steven Globerman

2
Background

• Most firms engaging in international
  transactions utilize foreign currencies
• Main foreign currencies for U.S. firms Euro,
  Yen, Canadian , Mexican Peso

3
The Activity

• Foreign currencies fluctuate in value against
  U.S. dollar
• Foreign-currency denominated cash flows will
  therefore fluctuate in value.
• Foreign currency denominated assets and
  liabilities will fluctuate in value
• Fluctuations mean risk and need for management of
  risk.
• The latter involves identifying, evaluating and
  mitigating potential losses

4
Spot and Forward Rates

• Spot Rate Rate of exchange for immediate
  delivery e.g. 1U.S. 1.5711CDN (on May 8,
  2002)
• Future Rate Rate of exchange for future
  delivery e.g. 1U.S. 1.5766CDN for 6 months
  forward (on May 8, 2002)
• Note 1month forward was 1U.S. 1.5718CDN.

5
What Determines Exchange Rates?

• Supply and demand
• Supply of U.S. dollars ultimately determined by
  demand for foreign goods, services and assets on
  part of Americans.
• Demand for U.S. dollars ultimately determined by
  foreign demand for U.S. goods, services and
  assets.
• Economic, political and social factors can all
  influence supply and demand.

6
Some Basic Determinants

• Differences in price levels or rates of inflation
  (Purchasing Power Parity). (Affects exports and
  imports).
• Differences in real rates of return on assets.
• Political uncertainties.
• Speculation?

7
Exchange Rate Exposure

• Potential consequences of exchange rate changes
  will be a function of exposure to specific
  currencies
• Short-term assets and liabilities
• Long-term assets and liabilities
• Competitive position in long-run
• Note The latter is most important in long-run.

8
Assessing Risks

• Exposure to different currencies might cancel
  out. What matters is net exposure.
• Relevant currencies may be quite stable. Need to
  identify range of possible changes and likelihood
  of different scenarios
• Different approaches to forecasting- forward
  market may be best.

9
Hedging

• Involves eliminating part of all of an exposed
  position at a cost.
• Common financial hedges
• Forward purchases/sales
• Money market swaps
• Forward swaps
• Options

10
Real Hedges

• Transact in home currency
• Diversify production locations
• Concentrate on products that are relatively price
  inelastic
• Invest in inflation-hedge assets in countries
  that are at risk of currency devaluations