South-Eastern Europe Journal of Economics 2 (2006) 129-146
EXCHANGE RATE RISK MEASUREMENT AND MANAGEMENT:
ISSUES AND APPROACHES FOR FIRMS
MICHAEL G. PAPAIOANNOU, Ph.D.
International Monetary Fund
Abstract
Measuring and managing exchange rate risk exposure is important for reducing a firm’s vulnerabilities from major exchange rate movements, which could adversely affect profit margins and the value of assets. This paper reviews the traditional types of exchange rate risk faced by firms, namely transaction, translation and economic risks, presents the VaR approach as the currently predominant method of measuring a firm’s exchange rate risk exposure, and examines the main advantages and disadvantages of various exchange rate risk
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The organization of the paper is as follows: In section I, we present a broad definition and the main types of exchange rate risk. In section II, we outline the main measurement approach to exchange rate risk (VaR). In section III, we review the main elements of exchange rate risk management, including hedging strategies, hedging benchmarks and performance, and best practices for managing currency risk. In section IV, we offer an overview of the main hedging instruments in the OTC and exchange-traded markets. In section V, we provide data on the use of various derivatives instruments and hedging practices by US firms. In section VI, we conclude by offering some general remarks on the need for hedging operations based on recent currency-crisis experiences.
M. PAPAIOANNOU, South-Eastern Europe Journal of Economics 2 (2006) 129-146
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1. Definition and types of exchange rate risk
A common definition of exchange rate risk relates to the effect of unexpected exchange rate changes on the value of the firm (Madura, 1989). In particular, it is defined as the possible direct loss (as a result of an unhedged exposure) or indirect loss in the firm’s cash flows, assets and liabilities, net profit and, in turn, its stock market value from an exchange rate move. To manage the exchange rate risk inherent in every multinational firm’s operations, a firm needs to determine the specific type of current risk exposure, the hedging strategy
The exchange rates risk that is associated with economic, transaction, and translation exposure in Indian market. From the analysis, anticipate the fluctuations that seem to occur in the next 24 months
Investment on securities such as shares, debentures, bonds are profitable as well as exciting. It is indeed rewarding but involves a great deal of risk. Shapiro (2006) describes the emergence and growth of the market for derivative instruments can be traced back to the willingness of risk averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. Kawaller, the President of Kawaller & Company, LLC and Managing Director of the Kawaller Fund in Brooklyn, NY (2008) analysed the prevailing scenario and stated that currency risk is an inherent aspect of international commerce. Fortunately, for enterprises that function in this space-particularly for those that transact with counterparties
Currency exposures assume many forms: they can be assets or liabilities; current or committed; contracted or merely forecast; they can be for trade, investment or balance sheet purposes. Cases of currency exposure can emerge at any point along the value chain, with various repercussions. Each requires a transfer of funds, and for each the rate of exchange is uncertain. Examples of different types of currency exposures are presented below.
There are lots of methods to solve the changes in foreign currency and interest rates issue, however, derivative financial instruments are the major tunes Nike enterprise has used to tackle this issue. Despite the fact that this approach does not wipe out comprehensively the risk of foreign exchange, Nike enterprise still utilize it to minimize or delay the negative consequences. Specifically, the derivative financial instruments comprise embedded derivatives, interest rate swap, and foreign exchange forwards and options contracts (Nike annual report, 2014).
Foreign Exchange Risk Management: HSE’s results are affected by the exchange rates between various currencies, including the Canadian and U.S. dollar. HSE enters into short-dates foreign exchange contracts to
This paper discusses how companies are managing the foreign exchange risk through the use currency options. For instance, some companies who didn’t not take risk management seriously had resulted in inefficient use of capital, increased liabilities, and reputation risk. Moreover, a lack of certainty can cause confusion as to what a company’s acceptance of risk is, such as a level of acceptance. Without risk management, a company can become overconfident in its methods, which could lead to a financial crisis. The failure to objectively take risks leads to bad results like a company taking inappropriate risks not in the best long-term interests of the firm. Furthermore, poor risk management in finance could amount to
There is also risk of volatility with respect to exchange rates in the short and long term
One way to avoid over-hedging is to hedge only the minimum known payment involved in the future transaction. By hedging a portion of the transactions, a company can reduce the sensitivity of its cash flows to exchange rate movements without creating serious mismatches between the hedge and the risk. In this way, ERM — which consists of managers taking a holistic view of their company’s various risks, prioritizing the material ones, and devising ways to curb them — can help CFOs identify the most volatile foreign exchange rates and reduce some of the guesswork involved in deciding how much of their foreign exchange risk to hedge.
Exhibit 7 from the case study describes the currency development in medium term of the GBP and EURO against the dollar. We can observe that the currencies are exposed to high volatility, which means the company may register greater risk
This research is devote to study different risks of one country holding sovereign currencies such as dollar, euro and yen as its reserve currencies. In general, there may have three kinds of risks, which include inflation risk, the exchange risk and the seignorage risk. It also tries to explain the effects of these risks on the reserve country from the perspective of currency resource allocation. The inflation risk have two forms: measurable depreciation risk from statistical sense and immeasurable depreciation risk which is a natural loss of value. At the same time, the exchange risk also can be explained in two
Table of this question shows the relationship between expected exchange rate and initial exchange rate of two countries like in USA and UK as given above. There are nine different combination of this table for the comparison of interest rate in UK and USA for getting the result that the investor should or should not invest in which country. 1st we examine option no one in which expected exchange rate is lesser than the initial exchange rate and in UK interest rate is greater then in USA.
The depth and intensity of exchange rate volatility and its impact on the volume of international trade was recognized during 1970s when the world economy shifted from fixed exchange rate to free floating exchange rate. The hypothesis may be that if the exchange rate volatility is higher then it will generate uncertainty of the future profit from
Among the most fundamental risks, associated with exchange-traded derivatives, is variable degree of risk. According to Ernst, Koziol, & Schweizer (2011), the transactions in
Great Eastern Toys is a company in Hong Kong that exports a huge percent of its total sales to the North American and European markets and hence is exposed to currency risk. Previously, the company was occupied with expanding their business and the company 's management had never given much attention to currency risk until their recent meeting with their banker. The banker pointed out that the depreciation of the European currencies during the previous two years had resulted in a substantial loss of income. The company 's management was indeed convinced that they should begin to devote more time and manage their currency position. In this report, we are going to explore the different options for Great Eastern Toys to hedge
Where P_t is the adjusted spot exchange rate at time t. The descriptive statistics summary of daily logarithmic returns is reported in Table 1. Therefore, assessing the exposure of currency risk was done by reviewing both return and risk profile for data sets.