6 • 1

CHAPTER

6

MANAGEMENT OF CORPORATE

FOREIGN EXCHANGE RISK

Gunter Dufey

University of Michigan and McKinsey & Co.

Ian H. Giddy

New York University

CONTENTS

6.1 Introduction 1
6.2 Should Firms Manage Foreign
Exchange Risk? 2
6.3 Economic Exposure, Purchasing
Power Parity, and the International
Fisher Effect 6
6.4 Identifying Exposure 8
(a) Transaction Exposure 10
(b) Accounting Exposure 10
(c) Critique of the Accounting
Model of Exposure 13
(d) Contractual versus Noncontrac-
tual Cash Flows 15
(e) Currency of Denomination
versus Currency of
Determination 16
6.5 Managing Economic Exposure 18
(a) Economic Effects of Unantic-

ipated Exchange Rate Changes

on Cash Flows 18

(b) Financial versus Operating

Strategies for Hedging 18

6.6 Guidelines for Corporate Fore-

casting of Exchange Rates 19

6.7 Tools and Techniques for the

Management of Foreign

Exchange Risk 23

(a) Foreign Exchange Forwards 24

(b) Currency Futures 24

(c) Foreign Currency Debt 25

(d) Currency Options 26

6.8 Conclusion 27

SOURCES AND SUGGESTED

REFERENCES 28

6.1 INTRODUCTION. “Corporate” exchange risk refers to the adverse effects that
unanticipated exchange rate changes can have on the value of the firm. This chapter
explores the impact of currency fluctuations on cash flows, on assets and liabilities,
and on the real business of the firm. At the onset, some basic questions must be an-
swered: What is exchange risk, how does exposure relate to it, and why is it of im-
portance to corporates at all? If foreign exchange risk is an issue that corporations
have to deal with, we need to know how they identify and measure their currency ex-
posure and, based on the nature of the exposure and the firm’s ability to forecast cur-
rencies, what exchange risk management strategy they should employ. Finally, guid-
ance is necessary regarding which of the various tools and techniques of the foreign