UNIT – 4

Foreign exchange risk management strategy

A foreign exchange risk management strategy or program is a set of procedures
that allows a company to achieve its goals in terms of managing currency risk. It is
based on the business specifics of the company, including its pricing parameters,
the location of its competitors, and the weight of FX in the business.

A foreign exchange risk management strategy or program also takes into account
the company’s sources of information, IT systems, degree of cash flow visibility,
and key decision makers (their risk tolerance, their familiarity with different risk
management styles, etc.

What Is Translation Exposure?

Translation exposure (also known as translation risk) is the risk that a company's
equities, assets, liabilities, or income will change in value as a result of exchange
rate changes. This occurs when a firm denominates a portion of its equities, assets,
liabilities, or income in a foreign currency. It is also known as "accounting
exposure.”

Accountants use various methods to insulate firms from these types of risks, such
as consolidation techniques for the firm's financial statements and using the most
effective cost accounting evaluation procedures. In many cases,
translation exposure is recorded in financial statements as an exchange rate gain
(or loss).

Transaction vs. Translation Exposure

There is a distinct difference between transaction and translation

exposure. Transaction exposure involves the risk that when a business transaction
is arranged in a foreign currency, the value of that currency may change before the
transaction is complete.
Should the foreign currency appreciate, it will cost more in the business’s home
currency. Translation risk focuses on the change in a foreign-held asset’s value
based on a change in exchange rate between the home and foreign currencies.

What Is Economic Exposure?

Economic exposure is a type of foreign exchange exposure caused by the effect of
unexpected currency fluctuations on a company’s future cash flows, foreign
investments, and earnings. Economic exposure, also known as operating exposure,
can have a substantial impact on a company’s market value since it has far-
reaching effects and is long-term in nature. Companies can hedge against
unexpected currency fluctuations by investing in foreign exchange (FX) trading.

What Is the Main Purpose of Economic Exposure Management?

The main purpose of economic exposure management is to reduce the impact that
changes in exchange rates have on the cash flows of a company. Economic
exposure management seeks to help companies preserve as much foreign profit as
they can when profits in foreign currencies are converted to the domestic
currency.

What Is Transaction Exposure?

Transaction exposure is the level of uncertainty businesses involved in
international trade face. Specifically, it is the risk that currency exchange
rates will fluctuate after a firm has already undertaken a financial obligation. A
high level of vulnerability to shifting exchange rates can lead to major capital
losses for these international businesses.

Transaction exposure is also known as translation exposure or translation risk.

Hedging
Hedging involves taking an offsetting (that is, contrary) position in an investment
in order to balance any gains and losses in the underlying asset (the one that backs
the derivative). By taking an opposite position, hedgers are trying to protect
themselves against no matter what happens, price-move-wise, with the asset—
covering all the bases, so to speak.

The ideal situation in hedging would be to cause one effect to cancel out another.
It is a risk-neutralizing strategy.

For example, assume that a company specializes in producing jewelry and it has a
major order due in six months, one that uses a lot of gold. The company is worried
about the volatility of the gold market and believes that gold prices may increase
substantially in the near future. In order to protect itself from this uncertainty, the
company could buy a six-month futures contract in gold. This way, if gold
experiences a 10% price increase, the futures contract will lock in a price that will
offset this gain.

Speculation
Speculators trade based on their educated guesses on where they believe the
market is headed. For example, if a speculator thinks that a stock is overpriced,
they may sell short the stock and wait for the price to decline, at which point it can
be bought back for a profit.

Speculators are vulnerable to both the downside and upside of the market;
therefore, speculation can be extremely risky. But when they win, they can win
big—unlike hedgers, who aim more for protection than for profit.

If hedgers can be characterized as risk-averse, speculators can be seen as risk-

lovers. Hedgers try to reduce the risks associated with uncertainty, while
speculators bet against the movements of the market to try to profit from
fluctuations in the price of securities. Both may swim against the tide of market
sentiment, but they do so out of very different motives.

Hedging vs. Speculation: An Overview

Hedging and speculation refer to strategic activities relating to investing, and
speculators and hedgers describe traders and investors of a particular sort. Aside
from both being fairly sophisticated strategies, though, speculation and hedging
are quite different.

Currency Option:
A currency option is a type of option that is based on an underlying currency. A
currency option gives the buyer the right but not the obligation to buy or sell the
currency at a specific price at a specific time