INTERNATIONAL FINANCIAL MANAGEMENT

Does Foreign Exchange Rate Exposure Matter for Companies Operating Internationally?



Table of Contents

Introduction3

Foreign Exchange Theories4

Purchasing Power Parity4

Example4

Interest Rate Parity5

Expectations Theory6

Principles of Transaction and Economic Exposure: Hedging7

Why Hedging?7

What does Hedging Seek to Achieve8

Hedging Long Term and Short Term Exposure9

Hedging Instruments9

How Currency and Exchange Risks are Dealt With?11

Foreign Exposure Hedging Policies: Examples of BMW and Lufthansa12

Currency Risk Management by BMW12

Currency risk management by Lufthansa Air13

Exchange rate risk faced by Lufthansa14

Foreign Exchange Rate Exposure and International Companies16

References19

Does Foreign Exchange Rate Exposure Matter for Companies Operating Internationally?

Introduction

Today's companies are facing a vast variety of risks in almost every aspect of their economic activities on a daily basis, which require to be carefully managed and tended to in order to secure the companies' future existence and profitability. In the past few decades, however, one risk in particular, and its management, have been and continue to be of major concern to the majority of enterprises - namely, foreign exchange rate risk. The collapse of the fixed exchange rates regimes in the 1970's and the followed adoption of floating exchange rates, as well as the steadily intensifying degree of globalization in world's economy have significantly exacerbated the importance of managing and minimizing the exchange rate risks.

The gradual reduction of trade restrictions such as tariffs and quotas, the internationalization of modern business and the rapid change in the technology of money transfers are just few of the factors that contributed to the rapid growth of world trade (Mathias, 2008,11-30). This raised the issue of how companies should manage the increased uncertainty and avoid or minimize the potential losses associated with movements in the exchange rates of these currencies. As such movements affect the costs of inputs, outputs and substitute goods, currency risk is borne by not only companies involved in international trade, but also by domestic non-exporting ones. It is rather transferred through the change in prices charged by suppliers, for example, than borne directly (Mathias, 2008,11-30). However, the result is change in competitiveness, which depends on the direction of movements in exchange rates.

Foreign Exchange Theories

Purchasing Power Parity

The theory of purchasing power parity was formulated by Gustav Cassel. According to this theory, natural value rate of exchange is the value corresponding to the purchasing power parity (Jack, 2003, 10-45). If the exchange rate of currency A exceeds the parity value of B, it becomes profitable to buy goods in country B and export it to A. This increases the supply of goods in country A, the demand for goods in country B, the demand for the currency of the country B, and supply of currency of country A, which leads to the return rate to parity.

Example

If the price per unit of goods in Malaysia is 30, and in the U.S., it is 2 dollar, the Ringgits against the dollar should be 15 Ringgits per dollar. If the rate of 25 Ringgits per dollar, then buying the goods in Malaysia (30 Ringgits), selling in the U.S. ($ 2) and exchanging the $ 2 for ...