Balance Sheet Hedge

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Chapter 11

balance sheet hedge. Reducing foreign exchange (FX) exposure by varying the mix of a firm’s foreign currency assets and liabilities.

Economic exposure. The effect of FX rate changes on a firm’s future costs and revenues.

Exposure management. Structuring a company’s affairs to minimize the adverse effects of exchange rate changes on earnings.

net exposed asset position. An excess of exposed assets over exposed liabilities (also called a positive exposure).
net exposed liability position. An excess of exposed liabilities over exposed assets (also called a negative exposure).

structural hedges. Selecting or relocating operations to reduce a firm’s overall FX exposure

translation exposure. Measuring the parent currency effects of FX changes on foreign currency assets, liabilities, revenues, and expenses.

transaction exposure. Exchange gains and losses that arise from the settlement (conversion) of foreign currency transactions.

The main goal of financial risk management at the individual risk level is to minimize the chance of loss arising from unexpected changes in the prices of currencies, credit, commodities, and equities. Exposure to price volatility is known as market risk.

The rapid growth of risk management services suggests that management can increase firm value by controlling financial risks.5 Moreover, investors and other stakeholders increasingly expect financial managers to identify and actively manage market risk exposures. If the value of the firm equals the present value of its future cash flows, active exposure management is justified on several grounds.

• First, exposure management helps stabilize a firm’s expected cash flows. Amore stable cash flow stream helps minimize earnings surprises, thereby increasing the present value of expected cash flows. Stable earnings also reduce the likelihood of default and bankruptcy risk, or the risk that earnings may not cover contractual...
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