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Foreign Exchange Risk Management

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Foreign-currency denominated cash flows will therefore fluctuate in value. ... What Determines Exchange Rates? Supply and demand ... Exchange Rate Exposure ... – PowerPoint PPT presentation

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Title: Foreign Exchange Risk Management


1
Foreign Exchange Risk Management
  • Steven Globerman

2
Background
  • Most firms engaging in international
    transactions utilize foreign currencies
  • Main foreign currencies for U.S. firms Euro,
    Yen, Canadian , Mexican Peso

3
The Activity
  • Foreign currencies fluctuate in value against
    U.S. dollar
  • Foreign-currency denominated cash flows will
    therefore fluctuate in value.
  • Foreign currency denominated assets and
    liabilities will fluctuate in value
  • Fluctuations mean risk and need for management of
    risk.
  • The latter involves identifying, evaluating and
    mitigating potential losses

4
Spot and Forward Rates
  • Spot Rate Rate of exchange for immediate
    delivery e.g. 1U.S. 1.5711CDN (on May 8,
    2002)
  • Future Rate Rate of exchange for future
    delivery e.g. 1U.S. 1.5766CDN for 6 months
    forward (on May 8, 2002)
  • Note 1month forward was 1U.S. 1.5718CDN.

5
What Determines Exchange Rates?
  • Supply and demand
  • Supply of U.S. dollars ultimately determined by
    demand for foreign goods, services and assets on
    part of Americans.
  • Demand for U.S. dollars ultimately determined by
    foreign demand for U.S. goods, services and
    assets.
  • Economic, political and social factors can all
    influence supply and demand.

6
Some Basic Determinants
  • Differences in price levels or rates of inflation
    (Purchasing Power Parity). (Affects exports and
    imports).
  • Differences in real rates of return on assets.
  • Political uncertainties.
  • Speculation?

7
Exchange Rate Exposure
  • Potential consequences of exchange rate changes
    will be a function of exposure to specific
    currencies
  • Short-term assets and liabilities
  • Long-term assets and liabilities
  • Competitive position in long-run
  • Note The latter is most important in long-run.

8
Assessing Risks
  • Exposure to different currencies might cancel
    out. What matters is net exposure.
  • Relevant currencies may be quite stable. Need to
    identify range of possible changes and likelihood
    of different scenarios
  • Different approaches to forecasting- forward
    market may be best.

9
Hedging
  • Involves eliminating part of all of an exposed
    position at a cost.
  • Common financial hedges
  • Forward purchases/sales
  • Money market swaps
  • Forward swaps
  • Options

10
Real Hedges
  • Transact in home currency
  • Diversify production locations
  • Concentrate on products that are relatively price
    inelastic
  • Invest in inflation-hedge assets in countries
    that are at risk of currency devaluations
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