Foreign Exchange Risk Management

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How is foreign exchange risk managed?
An empirical study applied to two Swiss companies.

Abstract

This paper investigates how two Swiss companies manage their foreign exchange risk and compares the results to theoretical findings and to previous empirical research. We find significant differences in the foreign exchange risk management policies, notably in the choice of the type of exposure to cover and in the hedging instruments used. Consistent with previous research, forwards and netting are the most used instruments and transaction exposure is the most managed foreign exchange risk. Surprisingly, translation and economic exposures are not well identified and managed mainly because firms believe it is unnecessary or too complex. Finally, firms hedge their exposure but never fully due to high cost of hedging.

Executive summary

Among the key findings are the following:

(1) Centralization of foreign exchange (FX) risk management is recommended by the theory. Logitech follows this recommendation whereas Kudelski uses a mixture of a centralized and non-centralized organization.

(2) Most firms, including Logitech and Kudelski, do hedge. Theory presents arguments both in favor and against hedging but the view in favor of hedging predominates. However, companies never hedge fully because it is expensive and they prefer to hedge in the short-term.

(3) Theory argues that a firm should first use internal hedging techniques and then, if necessary, pass to external hedging techniques. The main argument is that external hedging is costly. In practice, firms follow this strategy; Logitech and Kudelski do natural hedging whenever it is possible.

(4) Forwards and natural hedging are the most popular instruments to manage FX risk in practice. Both Logitech and Kudelski state them as their main hedging techniques. (5) Measuring FX risk can be very difficult and many firms decide to ignore it. Nevertheless, it is highly recommended by theory.

(6) Transaction exposure appears to be the most important FX risk in practice whereas economic exposure is considered as the relevant exposure in theory. (7) Translation exposure is often not hedged in practice and this corresponds to the theory recommendation. However, Kudelski hedges and measures this kind of exposure.

Introduction

Foreign exchange (FX) risk management has become increasingly important since the

abolishment of the fixed exchange rate system of Bretton Woods in 1976. This system was

replaced by a floating rates system in which the price of currencies is determined by supply

and demand of money. Given the frequent changes of supply and demand influenced by

numerous external factors, this new system is responsible for currency fluctuations. These

fluctuations expose companies to a foreign exchange risk. Moreover, economies are getting

more and more open with international trading constantly increasing, and companies become

as a consequence more exposed to foreign exchange rate fluctuations.

Foreign exchange risk management is crucial for companies frequently trading in the

international market. Empirical research shows that profits of multinational companies are

affected by volatile floating foreign exchange rates. Nevertheless, small firms trading

exclusively on their domestic markets also become increasingly exposed to foreign currency

fluctuations. Actually, small firms depend on the volatility of the main currencies because

many of them out-source their production to foreign countries. This means that they incur

costs in a foreign currency (wages, taxes, material, etc.) and they also need to manage this

exposure. Other small firms are exposed indirectly given that their strategic position can be

affected by volatile FX rates.

The thesis is divided into two parts: the...
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