MANAGING FOREIGN EXCHANGE-RATE RISK

Managing Foreign Exchange-Rate Risk

Managing Foreign Exchange-Rate Risk

Introduction

When a company begins a transaction in a foreign currency, it accepts an economic risk due to fluctuating exchange rates. The globalization of the world economy and the devaluation of the U.S. dollar have allowed more American companies to enter the export/import markets. Additionally, many managers who previously avoided these markets are finding that international transactions can make their companies more competitive in marketing products and procuring parts and materials. As new companies are exposed to foreign exchange risk, managers will necessarily be concerned with the development of an effective hedging program. While the task of managing financial risks generally falls to the CFO or treasurer, it is often others in the accounting department who are asked to evaluate the bottom line impact of these risks.

Importance of effective foreign exchange-rate risk management

The exchange rate stated simply is the price of one currency in terms of another currency. Exchange rate can therefore be expressed in terms of the law of one price which states that "in the presence of a competitive market structure and the absence of transportation cost and other barriers to trade, identical products which are sold in different markets will sell at the same price in terms of a common currency" (Pilbeam, 1992). Importers and exporters are exposed to the fluctuation in foreign currency (FC) exchange therefore undergoing business risks as they operate mainly in international markets. They are, in global market terms, therefore affected by the fluctuation mainly in the value of the US dollar, the Euro and to a lesser extent the British pound, and other foreign currencies. In principle, in the normal course of doing business, importers and exporters employ derivatives financial instruments, including forward contracts and foreign currency options to manage their exposure to fluctuation in foreign currency exchange rates. To take New Zealand importers and exporters for example, the value of the NZ dollar has raised generally for the past three years against the US dollar and the Euro though there had been periods of fluctuations. Changes in foreign exchange rate affect NZ participants' revenue, gross margins, operating costs, operating income, net income and retained earnings. In addition, there are some other important approaches to contribution to hedge or control foreign exchange risk, including using a value-at-risk analysis ("VAR"), leading and lagging, netting, back to back loans, natural hedging and so on. For either existing or potential participants of international import and export, how to evaluate the foreign currency risk and implement effective risk strategic management to minimize exposure is critical.

Methods and techniques to manage foreign exchange-rate risk.

Participation in international markets may result in a foreign exchange risk known as transaction exposure. This risk occurs when a company has a payable (or receivable) denominated in a foreign currency (FC). The risk lies in the fluctuation of the FC exchange rate. For example, if the FC appreciates before the liability is settled, the company has to pay more dollars to purchase the FC needed to ...