Managing forex exchange rate risk

Changes in exchange rate give rise to foreign exchange risk, the firms dealing with other currencies usually face foreign exchange risk. Firms that import and export often need to make commitments to buy or sell the goods for delivery at some future time, with the payment to be made in foreign currency. Likewise, firms operating foreign subsidiaries receive payment from these subsidiaries in foreign currency and have to convert this receipt into domestic currency. In addition, the firm may also be exposed to political and regulatory risk of the other countries.

As soon as, a firm enters into a transaction that exposes it to the cash flows in a foreign currency, it is exposed to exchange rate risk. The financial manager can either leave the firm exposed to these risk and assume that the shareholders would be able to diversify away the risk; or can hedge the risk using a variety of options available. However, the options available to a firm for hedging against exchange risk are subject to the following:

a) Shareholders composition: For the shareholders to be able to diversify away foreign exchange risk that flows to the firm, they must be having internationally diversified portfolio. Thus, an investor who holds shares of the U.S. as well as the British firm may not be affected much by the movements in $/Yen rate because of offsetting effects of his investment. If on the other hand, if the shareholders are not internationally diversified, then the firm should try to diversify the risk itself.

b) Diversification across countries: Some firms accomplish a diversification of different kind by exposing to many countries and many currencies. For example Coca Cola having operations in a number of countries is less likely to be concerned about hedging the exchange rate risk.

c) Hedging risk: The cost of hedging risk in some currencies is less than hedging in other currencies or cost of hedging for a shorter period may be less than the cost of hedging for a longer period. Other thinks remaining same, the greater the cost of hedging risk, the less likely it is that the firms will be able to hedge.

The introduction of floating exchange rates in the early seventies has motivated companies to develop strategies to protect their bottom line from the adverse consequences of exchange rate fluctuations. An action that removes foreign exchange risk is said to cover that risk. The covering of foreign exchange exposure imposes certain costs on the companies. The companies have to strike a balance between foreign exchange risks and the costs of covering them. The systems to manage foreign exchange risks are guided by many factors in the companies, e.g., degree of centralization of foreign exchange transactions, accounting systems, responsibility for developing and complementing strategies, types of exposures to be managed system of formulation of corporate objectives and the design of the follow-up system to evaluate exchange risk management. Two of these most significant factors are discussed below:

i) Degree of centralization: In some of the companies, the policies to manage foreign exchange risk are decided at the head-office and the strategies are developed and implemented at the operating level. In the system, the administrative cost to manage foreign exchange may be low. However, the strategy may not be properly co-ordinated in the absence of perfect inter-divisional netting. In other companies, the policies as well as strategies are formulated at the head quarters. The implementation of the policies, in these companies, is done by the operating units. This system may involve high administrative costs but it is more effective. These companies are able to utilize various exposure management techniques. This system also helps in having maximum centralization of all the activities in the foreign exchange management system. However, it involves, like the first system, higher administrative costs and requires frequent reporting by various operating units.

ii) Statement of objectives: The primary objective of foreign exchange risk management is to eliminate or reduce variations in the future earnings of a company due to unexpected currency fluctuations. The companies, to achieve this objective, should identify the types of exposures, which they would like to monitor. Moreover, they should convert this primary objective into a number of specific operational goals related to the types of exposures being managed. The operational objective of translation exposure management, for instance, may be to minimize half-yearly fluctuations in earnings due to exchange rate variations. The acceptable total cost of exposure management (including the cost of management time) should also be included in the statement. moreover, proper exposure management would save the company from excessive speculation.