Exchange Rate Risk Hedging

Exchange Rate Risk Hedging

Introduction

Exchange rate management is among the primary tools that are used by firms that have a diverse international portfolio and want to manage their foreign currency exposure (Latter 1996, p5). The strategies that are used in order to decrease or eliminate the currency risk are called Currency Risk Hedging. This requires a solid understanding of the implications that fluctuation in currency risk can have on the sustainability of the economy and how they can be managed (Dhanani 2002, p36). The dilemma and complexity inherent in finding a middle-way strategy that can be used to measure the current risk exposure and the acceptable level of risk exposure that needs to be covered. The break down of the Breton Woods System and the fall of US dollar peg system in 1973 increased the awareness for developing effective risk management strategies.

Corporate treasury department is independently responsible for managing currency risk for pure business firms that do not primarily deal in financial markets. Furthermore, some multinational organizations go to the extent of having an exclusive Risk Committee to control and supervise the strategies developed by treasury department to manage exchange risk effectively (Papaioannou 2006, p130). This provides insight into the importance that is given to the effective management of currency risk in the financial industry. However, the international investors do not always manage their exchange rate risk separately from the principal assets.

This essay aims to examine the practices that are usually adopted in the management of exchange rate risk while focusing on hedging approaches. Moreover, the advantages and disadvantages of these hedging approaches will be discussed in great detail.

Discussion

Exchange Rate Risk

Exchange rate risk can be defined as the effect that a firm value faces in the consequences of sudden flux in exchange rate (World Bank 2003, p1). In theoretical sense, it is the direct loss from the risk exposure or the loss in a firm's cash flows, assets and liabilities, and the value of the stock due to changes in exchange rate is called exchange rate risk. Therefore, it becomes increasingly important for multinational firms to determine its risk appetite and devise an appropriate hedging strategy that makes use of the different tools and instruments available to it.

Multinational firms are particularly exposed to currency risk due to the vast number of operations that they are involved in. For example, Barclays bank operates in a number of global destinations and therefore needs to devise a hedging strategy to keep generating revenues from its international operations. In order to measure the impacts that currency exchange rates movements can have on a company that is involved in transacting in foreign denominated currency, there are two things that are needed. The first is the need to isolate and identify the risk type that impedes the company's progress and second is the size of the risk (Hakala 2002).

Shapiro (1996) identified three types of currency risks

Transaction Risk

Transactional risk originates from the effect that exchange rate changes can have on the international transactions that include ...