FOREIGN EXCHANGE-RATE RISK

Foreign Exchange-Rate Risk Management

“Foreign Exchange-Rate Risk”

Importance of Foreign Exchange Rate Risk

Foreign exchange ("FOREX") risk management may be defined as managing exposure to adverse exchange rate fluctuations within an acceptable range at an acceptable cost (Titscher, 2000). Companies especially multinational companies are now exposed to risks caused by unexpected movements in exchange rate (Titscher, 2000). The management of foreign exchange risk has become essential for the survival of companies in today's volatile financial markets (Telefónica, 2007).

The increasing globalization of the property-liability insurance industry has provided insurers with both opportunities and challenges (Telefónica, 2007). The opportunities revolve new markets with profit potential and diversification possibilities. On the other hand, companies with multinational operations and/or investments are exposed to the risk that foreign exchange rates will change, possibly adversely, in the future (Suarez, 2002). This paper examines the sources of foreign exchange risk, and & success the institutional techniques - e.g., financial derivatives. Some anecdotal evidence is provided to indicate how some insurers actually do manage foreign exchange risk (Suarez, 2002). Foreign exchange (FOREX) risk is the risk that profits will change if FOREX rates change. FOREX risks present complicated transfer pricing issues. Under today's system of floating FOREX rates, currencies often move dramatically over short periods (Shapiro, 2003). In one two-day period in 1998 the yen/U.S. dollar exchange rate moved nearly 20 percent. Empirical studies demonstrate that FOREX volatility can significantly affect companies' profits (Shapiro, 2003).

The volatility of floating FOREX rates has a significant impact on the profits of multinational businesses (Roulstone, 2009). Most researchers have measured the impact by studying how changes in FOREX rates affect market capitalization (Roulstone, 2009). Researchers consistently find that periods of significant FOREX movements produce substantial changes in stock market capitalization.

Therefore it is very important for the companies to use an effective foreign exchange rate risk management system (Pantzalis, 2001). Businesses invest in other countries to enhance their profitability through increased sales, economies of scale, reduced costs and diversified operations (Pantzalis, 2001). FOREX fluctuations can significantly alter international investment performance, but can be managed in a variety of ways.

As discussed above, the international monetary system of floating exchange rates has brought higher volatility to currency markets. Econometric models for predicting FOREX movements generally are unreliable (Nguyen, 2003). Accordingly, FOREX risk management has increased dramatically in importance since the advent of the floating FOREX system, although remaining unhedged is an option.

FOREX risk can be managed in a number of ways, but most of the techniques can be grouped into two broad categories: 1) “natural” hedging; and 2) hedging with financial instruments/derivatives (Nguyen, 2003). Risk management techniques vary depending on the type of FOREX risk involved (i.e., transnational vs. economic, etc.).

Multinational businesses are affected by and address FOREX risk in many and varied ways. Natural hedges such as asset/liability matching or geographic diversification of operations are inherently the most effective and cost efficient methods to reduce economic FOREX risk (Miller, 2008). Financial instruments can counteract transactional risk, and in some cases, remove a large amount ...