exchange market they should employ: forwards and futures; options or the specifica-
tion of debt and assets? The chapter concludes by suggesting a framework that can
be used to find the appropriate hedging instrument for a certain type of exposure.
In order to lay the foundations for the following sections, it is important to under-
stand what foreign exchange risk in the context of a corporation is, and how it relates
to the concept of exposure. Exchange risk originates from the (random) fluctuations
of foreign exchange rates. It can be measured by the variance of the value of mone-
tary as well as real assets and liabilities and the operating income of a company that
is caused by unanticipated changes in the exchange rates. The emphasis here is on
unexpected changes, as anticipated changes in the foreign exchange rate—as well as
all other available information—are already reflected in market prices. In most cur-
rencies there exist futures or forward exchange contracts whose prices give firms an
indication of where the market expects currencies to go. And these contracts offer the
ability to lock in the anticipated change.
Exchange rate volatility is by itself a necessary, but not sufficient, condition for
foreign exchange risk: Indeed, some firms may not be affected by foreign exchange
rate changes at all. Thus, what is required is to assess foreign exchange exposure that
quantifies the sensitivity of the value of assets, liabilities, and operating income with
respect to exchange rate variations. The concept of exposure describes the effect that
exchange rate changes have on these values: It is the value at risk. Therefore, it is ul-
timately foreign exchange exposure that is relevant for each individual corporation.
One of the consequences of this conclusion is that a corporation may decide to take
operating measures that alter its exposure as one way to manage the underlying ex-
change risk (Levi, 1996).
From this notion of exchange risk, several complex issues arise. First, the right
perspective has to be determined: From the company’s point of view, it could well be
that there are offsetting positions elsewhere in the firm, so exchange risk might not
matter because there is no exposure. But how about future cash flows that are not yet
contractually fixed but anticipated? For nonfinancial firms these future cash flows re-
flect the basis of their current value! Thus, they should surely be part of the analysis,
too, when determining the corporate risk profile.
Last but not least, the company belongs to its shareholders. Therefore, it might be
appropriate to look at the issue from their perspective, that is, maximization of share-
holder wealth, as postulated by modern finance. Yet the impact of any given currency
change on shareholder value is difficult to assess; and frankly, the empirical evidence
linking exchange rate changes to stock prices is weak.
Moreover, the shareholder who has a diversified portfolio may find that the nega-
tive effect of exchange rate changes on one firm is offset by gains in other firms; in
other words, exchange risk is diversifiable. Thus, an investor may be concerned with
such a risk. This means that one has to investigate whether—and if so, why—it
makes sense to deal with foreign exchange risk on the corporate level at all.
6.2 SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK? Some firms refrain
from active management of their foreign exchange, even though they understand that
exchange rate fluctuations can affect their earnings and value. They make this deci-
sion for a number of reasons.
First, managers do not take time to understand the issue. They consider any use of
risk management tools, such as forwards, futures, and options, as speculative. Or they
argue that such financial manipulations lie outside the firm’s field of expertise. “We
6 • 2 MANAGEMENT OF CORPORATE FOREIGN EXCHANGE RISK