Exchange rate risk management is an important part of an organization that is concerned with the firm’s decisions about foreign currency exposure. The exchange rates affect all the companies that are in the market and therefore the companies have to be updated so as to reduce the exchange rate risks. In the present international market, changes in the exchange rates have a significant influence on the operations and profits of the organization (Miller, 1992 pg. 311-331). It is important for the organization to understand the exchange in the global market so that it can be able to operate effectively in the present market. Exchange rate risk is the risk that changes in the relative value of certain currencies and it will reduce the value of the invested capital denominated in a foreign currency.
Importance of managing exchange rate risk
Determining operating exposure
It deals with unexpected changes in the exchange rates which are impossible to predict and therefore the company’s management has to allocate some money and focus on the future expected changes in the currency. Operating exposure is determined by the market where the company sells its product and acquires its input (whether monopolistic or competitive). According to Goh and Meng, 2007 pg. (164-173), the operating exposure is higher when either the firm’s input costs or product prices are sensitive to currency fluctuations.
The flexibility of the market so that the company can be able to determine if it can adjust its market in case of currency fluctuations. Through this, the company is able to get through the unexpected exchange rates since it had anticipated for it and had set a budget for the same.
Managing operating exposure
The company has to put into place some strategies that can be used to manage the exchange rate whereby the first one is, Matching of the currency flows which is a is a plan which requires foreign currency influxes and also outflows to be coordinated (Kapila and Hendrickson,2001 pg. 186-191). For example in the U.S.A a Company has an important inflow in euros and is always in the look for increased debt, then it should make a decision to consider borrowing in euros.
We also have the credit swap and this is an agreement that bounds two companies situated in different countries that are supportive to borrowing from the currency each other for a specified period of time after which the loans are paid back. The loan has equivalent collateral in foreign currency, therefore, it is both a liability and an asset on both companies.
Diversification of production facilities and the market for products as another key point and it helps to spread the risk in one product or market. Through this, the company can be able to continue with one product or market if the other fails (Zhi, 1995 pg. 231-237). Lastly Diversifying financing is also when a company has a good access to the capital markets in numerous main countries for example the U.S.A. This helps the company raise funds using the cheapest cost.
Types of exchange rate risks faced by the firms
The transactional risk is a risk that arises as a result of the exchange rates fluctuations effects on the company and its duties to obtain or make expenditures that are in foreign currency. Conversion risk is a balance exchange rate risk that relates to the exposure that arises from the effect of currency fluctuations. Particularly applies when there are foreign rates and it is from medium to long term.
Economic risk reflects on the firm’s risk on the future operating cash flows to the current cash flows which involve, the unexpected changes in revenues which a company cannot be able to predict because it bases its budget on the present assumptions (Froot and Stein, 1994 pg. 22-33). This will, in turn, affect the company’s competitive nature in the future.
Due to the counterparts in the exchange rate, the exporter changes the design in the form of rules and regulations followed by the investors so as to protect their profit margins. The strategy helps the exporter not to be shaken away from the profit gained in the foreign exchange rates. The transaction foreign exchange risk is hedged by the use of standard products, which will be expensive in the future and also offshoots with short developments. It can be trundled over long term exposure in which rolling over the short term instruments will not help in the elimination of the risk. Natural hedges can help in the reduction of the foreign exchange rate exposures since foreign currency are functional substitutes to the forwards and futures. In this, the loan will cover the longer maturities tan derivatives (Dufey and Srinivasulu, 1983 pg. 54-62). Matching of the external currency revenues with foreign currency expenditure helps in reducing the exchange rate experience. This is done by geographical diversification of production, sourcing, and sales so as to know the value of exchange rates from the cost incurred. It will also help in the offering protection against the translation of risk due to both parties being aware of the translations done and the exchange involved and it will help manage the risks involved in the foreign exchange rates.
Theoretical considerations on invoice hedging.
Through invoicing in the domestic currency it’s evident that the exporter is a position to change transaction risk to the customer who is abroad. This is done through the invoice that is sent to the customer. In this document, one might be expecting a large interest but once the economic and market risks are taken into account the interest comes as unexpected but the invoice helps in explaining it better to help manage the risk that might be involved in it.
When invoicing the exporter uses the domestic currency in which the prices will not adjust instantly with the customer’s currency. This will cause the exporter suffering the risk of reduction in demand due to economic risk. This will only be helped by the chosen preferred invoicing currency and the instability of the conversation rate so that the risk can be managed.
Arbitrage: A strategy in hedging that involves taking two positions in the market. This will help in hedging physical pricing of similar products in different markets. The strategy will enable one not to incur the cost of the same good being cheaper in one market and at the same time being expensive in another market.
Averaging: A hedging strategy whereby hedging against a single price fixed on a single product, it takes the average transactions observed over a period of time so as to settle on a specified price of the item. This will help to manage the risk of foreign exchange rates on pricing individual items basing on the trend of the demand.
Offset: It involves the offsetting of the current exchange rates and creating new ones in the market. This is done to avoid the varying of the exchange rates within the products and enable equalize the exchange rates and avoid any Risk that may occur.
Price fixing: Price fixing is a hedging strategy that involves taking advantage of the current market levels with future physical transactions. This strategy will enable eliminate the risks in foreign exchange rates that will be involved in the future because they would have been fixed already.
Operational and financial hedging
Hedging helps in the reduction of a firm’s current and future cash flows. To meet its objectives, it uses financial hedging such as interests and commodity derivatives to reduce the volatility of its cash flows. A firm can also use operational hedging on the operation and investment activities of a firm to reduce cash flow uncertainty. This implies that financial and operational hedging are compliments of each other because the operations run in a firm greatly depends on the financial capability of a firm to finance the operations thus complementing each other.
The financial operations can be used to help to protect against a particular risk. This is done by the use of derivatives, swaps, and futures. Either the operational hedges are the consequences based on a firm’s real decision. A firm will include in working hedging only when the indecision of exchange rates and uncertainty of demand are present. In this context, both are not known and it will help in the reduction of the foreign exchange rates due to the firm operating under unknown rates and demand. Due to the indecision of demand and foreign exchange rates, the operational hedge is not applicable for the short term, it is applicable in the long term. It is only suitable for commodity-based firms which only face price not the quantity of uncertainty (Saunders, A., Cornett, M.M. and McGraw, 2006). Financial hedging applies for firms with both national and foreign location. This is because the foreign currency exchange rates will not be independent, they will vary depending on the financial currency of both of the locations. The financial hedging cannot be implemented on forward contracts, in case it can be implemented using foreign currency by the use of the call and out option on the investment strategy. Firms that use operational hedging do not lower their exchange rate risk while the ones that are employing financial hedging strategies helps them reduce the exchange rate risk. The operational hedging helps in the value addition of a firm rather than financial hedging because the operations in firm basing on its operations determine the long term capability of a firm to continue operating and the operations help in the addition of value to the firm. The addition of value under operational hedge comes about if only the firm is in conjunction with financial risk management.
Does hedging add value to the firm?
Allayaniss and Weston(2001) find out that hedging adds value to them because the firm holds derivatives positions that are small compared to the risks that they face.
According to Modigliani-Millers’s, they find out that hedging influences the cash flow of the firm and this is because the market structure is not perfect. Carter et al (2006a, b) study on fuel hedging industry results show that jet fuel hedging can increase firm value and the hedging premium is economically significant. Though it is argued that risk management has no profit.
U.S firms show that foreign exchange risk management can increase firm value. This is in the context where foreign exchange rates are managed well in order to be able to have value to a firm. The firm value can also be increased in foreign exchange risk management if many of their competitor’s hedge (Papaioannou, 2006). Hedging helps to reduce financial distress costs for firms with stable foreign exchange risks during the financial crisis. For hedging to be of great importance, managers should manage their hedging strategy based on changing the economic environment not only focusing on the firm’s financial value. In general, hedging adds value to a firm since investments are taken out so as to manage the risks that might be involved in a particular asset basing on the fluctuations of the prices. The hedge is of great importance to firm’s success.
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