The value of a firm can be thought as the net present value of all expected cash flows. If the firm’s future cash flows are largely affected by changes in exchange rates the firm is said to have large foreign exchange exposure. Traditionally the foreign exchange exposure is divided into three elements (Eiteman et al., 1995):
1. Transaction exposure: the effect of possible changes in exchange rates on identifiable obligations of the company. The risk arises from the imbalance of net currency cash flows based on commercial, financial or any other committed cash flows in a given currency.
2. Accounting exposure: arises from consolidation of assets, liabilities and profits denominated in foreign currency when preparing financial statements (also called translation exposure).
3. Economic exposure: extends the exchange exposure beyond the current accounting period. Arises from the fact that changes in future exchange rates may affect the international competitiveness of a firm and therefore, the present value of future operating cash flows generated by firm’s activities (also called operating or competitive exposure).
Increased economic uncertainty translates into higher levels of financial market volatility. This, in turn, subjects any given exposure to a greater degree of risk. This risk is the subject of foreign exchange management whose importance has increased in the turbulent financial environment in recent decades.
Reducing a firm’s exposure to exchange rate fluctuations is called hedging. The goal of hedging is to reduce the volatility of a firm’s pre-tax cash flows and hence to reduce the volatility of the value of the firm.
The relevance of risk management is an interesting topic itself. Traditional finance theory suggests that, given well-diversified portfolios of investors, hedging would not benefit shareholders. The usual reasoning is that investors can diversify their portfolios to manage the exchange risk in a way that matches their preferences. Some argue, however, that managers have better information concerning the current exposure of the firm than investors. Also, hedging reduces the probability that the firm goes bankrupt and reduces agency costs between shareholders and bondholders (Smith et al., 1995).
The findings of Nance et al. (1993) suggest that firms which hedge have more complex tax schedules, have less coverage of fixed claims (the probability of the firm encountering financial distress increases with lower coverage, the coverage of fixed claims being measured as the earnings before interest and taxes divided by total interest expense), are larger, have more growth options in the investment opportunity set and employ fewer “substitutes for hedging.” Firms with fewer substitutes have fewer liquid assets and higher dividends. The explanation is based on the idea that firms have, in addition to hedging, alternative methods to reduce the conflict of interest between shareholders and bondholders.
Many techniques and instruments have been developed for controlling financial risk. The process that seeks to develop new hedging instruments is called financial engineering. Due to increasingly important international operations of companies and high volatility in exchange rates, financial engineering has become an industry of enormous growth in recent years. However, the basic tools of financial engineering were developed many years ago. The basic hedging tools to control foreign exchange risk are:
1. Currency forwards are binding agreements between a buyer and a seller calling for the trade of a certain amount of currency at a fixed rate in a certain date in the future. The buyer benefits if prices increase by the settlement date. Correspondingly, the seller benefits from a price decrease.
2. Currency futures are similar to forward contracts with a few exceptions. First, gains and losses are realized each day, not only at the settlement date. The process is called marking to market. Second, futures are traded at organized exchanges while trading in forwards occurs between banks and firms mainly by telecommunication linkages.
3. Currency options are contracts that give the option buyer the right, but not the obligation, to buy (call option) or sell (put option) a certain amount of currency at a fixed price for a prespecified time period.
4. Currency swaps are transactions in which two parties agree to exchange an equivalent amount of two different currencies for a specified period of time.
Empirical studies suggest that swaps and forwards are the most frequently used external (or, off-balance sheet) hedging instruments. Be side these instruments, firms use internal possibilities for managing exchange risk, i.e. matching, exchange rate clauses, leading and lagging, etc. There are numerous ways of hedging and financial engineering actively produces new complex instruments for firms’ use. Now it becomes extremely important for managers to have clear goals for risk management. Without a clear set of risk management goals, using derivatives can produce problems. Therefore, a firm’s risk management strategy must be integrated with its overall corporate strategy (Froot et al., 1994).
While most of hedging instruments are suitable for controlling both the transaction and accounting exposures their benefit is limited when managing economic exposure. Because economic exposure is rooted in long-term international fundamental forces, it is much more difficult to hedge on a permanent basis. At the same time, its significance as a prerequisite of long-term profitability of a firm has increased in recent decades. Yet, many multinational companies have been reluctant to consider economic exposure as an important strategic risk.
