A Global Manager's Guide to Currency Risk Management
B06-03-0006
A Global Manager’s Guide to Currency Risk Management
Introduction
Since the advent of the floating exchange rates, any time that a transaction—whether that transaction is in goods, services, people, capital, or technology—has crossed borders, it has been subject to the influence of changes in exchange rates. The basic problem posed by exchange rates on the cross-border firm is that money across borders has no fixed value. Consequently, neither does a transaction undertaken across borders. In this Note, our purpose is to understand, categorize, and define the specific types of exchange rate risks that firms face across borders, and to address how managers can plan for, manage, and hedge these risks. Specifically, this Note provides an overview of the risks posed by exchange rates to the cross-border firm and the major strategies and solutions managers can employ to deal with them.
Why Should Companies Hedge?
Peter Drucker once noted that, “Not to hedge is to speculate. Exchange rates are a cost of production that financial executives must manage.”1 But what constitutes hedging and what constitutes speculation? What is the purpose of hedging? How, if at all, does hedging create value for shareholders? An exchange rate hedge is an asset or position whose value changes (∆H) in the opposite direction to that of an exposure (∆X) as a result of a change in the exchange rate. A perfect hedge would be one whose value changes in an equal and opposite direction, resulting in a net change of zero in the value of the combined position:2 ∆V = ∆X + ∆H Hedging therefore protects the owner of the existing asset from loss. It is, however, important to note that while a hedge protects the firm against an exchange rate loss (relative to being unhedged), it can also eliminate any gains from an exchange rate change that is favorable. But this does not really answer the question as to what is to be gained from hedging. The value of a firm is simply the net present
A Global Manager’s Guide to Currency Risk Management
Introduction
Since the advent of the floating exchange rates, any time that a transaction—whether that transaction is in goods, services, people, capital, or technology—has crossed borders, it has been subject to the influence of changes in exchange rates. The basic problem posed by exchange rates on the cross-border firm is that money across borders has no fixed value. Consequently, neither does a transaction undertaken across borders. In this Note, our purpose is to understand, categorize, and define the specific types of exchange rate risks that firms face across borders, and to address how managers can plan for, manage, and hedge these risks. Specifically, this Note provides an overview of the risks posed by exchange rates to the cross-border firm and the major strategies and solutions managers can employ to deal with them.
Why Should Companies Hedge?
Peter Drucker once noted that, “Not to hedge is to speculate. Exchange rates are a cost of production that financial executives must manage.”1 But what constitutes hedging and what constitutes speculation? What is the purpose of hedging? How, if at all, does hedging create value for shareholders? An exchange rate hedge is an asset or position whose value changes (∆H) in the opposite direction to that of an exposure (∆X) as a result of a change in the exchange rate. A perfect hedge would be one whose value changes in an equal and opposite direction, resulting in a net change of zero in the value of the combined position:2 ∆V = ∆X + ∆H Hedging therefore protects the owner of the existing asset from loss. It is, however, important to note that while a hedge protects the firm against an exchange rate loss (relative to being unhedged), it can also eliminate any gains from an exchange rate change that is favorable. But this does not really answer the question as to what is to be gained from hedging. The value of a firm is simply the net present