balance sheet hedge. Reducing foreign exchange (FX) exposure by varying the mix of a firm’s foreign currency assets and liabilities.
Economic exposure. The effect of FX rate changes on a firm’s future costs and revenues.
Exposure management. Structuring a company’s affairs to minimize the adverse effects of exchange rate changes on earnings.
net exposed asset position. An excess of exposed assets over exposed liabilities (also called a positive exposure).
net exposed liability position. An excess of exposed liabilities over exposed assets (also called a negative exposure).
structural hedges. Selecting or relocating operations to reduce a firm’s overall FX exposure
translation exposure. Measuring the parent currency effects of FX changes on foreign currency assets, liabilities, revenues, and expenses.
transaction exposure. Exchange gains and losses that arise from the settlement (conversion) of foreign currency transactions.
The main goal of financial risk management at the individual risk level is to minimize the chance of loss arising from unexpected changes in the prices of currencies, credit, commodities, and equities. Exposure to price volatility is known as market risk.
WHY MANANGE FINANCIAL RISKS?
The rapid growth of risk management services suggests that management can increase firm value by controlling financial risks.5 Moreover, investors and other stakeholders increasingly expect financial managers to identify and actively manage market risk exposures. If the value of the firm equals the present value of its future cash flows, active exposure management is justified on several grounds.
• First, exposure management helps stabilize a firm’s expected cash flows. Amore stable cash flow stream helps minimize earnings surprises, thereby increasing the present value of expected cash flows. Stable earnings also reduce the likelihood of default and bankruptcy risk, or the risk that earnings may not cover contractual debt service payments.
• Second, active exposure management enables firms to concentrate on their primary business risks. Thus, a manufacturer can hedge its interest rate and currency risks and concentrate on production and marketing. • Third, debt holders, employees, and
customers also gain from exposure management. As debt holders generally have a lower risk tolerance than shareholders, limiting the firm’s risk exposure helps align the interests of shareholders and bondholders.
• Fourth, derivative products allow
employer-administered pension funds to enjoy higher returns by permitting them to invest in certain instruments without having to actually buy or sell the underlying instruments.
• Fifth, because losses caused by certain price and rate risks are passed on to customers in the form of higher prices, exposure management limits customers’ exposure to these risks.6
In a world of floating exchange rates, risk management includes (1) anticipating exchange rate movements, (2) measuring a firm’s exposure to exchange risk, (3) designing appropriate protection strategies, and (4) establishing internal risk management controls.
Information frequently used in making exchange rate forecasts (e.g., currency depreciation) relates to changes in the following factors:
Inflation differentials. Evidence suggests that a higher rate of inflation in a given country tends, over time, to be offset by an equal and opposite movement in the value of its currency.
Monetary policy. An increase in a country’s money supply that exceeds the real growth rate of national output fosters inflation, which affects exchange rates. Balance of trade. Governments often use currency devaluations to cure an unfavorable trade balance (i.e., when exports < imports).
Balance of payments. A country that spends (imports) and invests more abroad than it earns (exports) or receives in investments from abroad experiences downward pressure on its currency’s value.
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