Page 155 - Microsoft Word - 00 P1 IW Prelims.docx

Hedging foreign exchange risk

Types of risk

Firms may be exposed to three types of foreign exchange risk:

 Transaction risk

– the risk of an exchange rate changing between the
transaction date and the subsequent settlement date on an
individual transaction

– associated with exports/imports

– hedge using a variety of financial products/methods

 Economic risk

– includes the longer-term effects of changes in exchange
rates on the market value of a company (PV of future cash
flows)

– looks at how changes in exchange rates affect
competitiveness, directly or indirectly

– reduce by geographic diversification

 Translation risk

– how changes in exchange rates affect the translated value of
foreign assets and liabilities (e.g. foreign subsidiaries)

– gains/losses usually unrealised so many firms do not hedge

– can hedge by borrowing in local currency to fund investment

143