makers. In contrast to linear instruments like futures and forwards, the value of an
option does not depend on the price of the underlying instrument alone, but also on
its volatility and the remaining time to expiration. As a consequence, using currency
options in the absence of a matching exposure means speculation with respect to one
or more of these determinants. Therefore, just having a view on the currency’s di-
rection that is different from the forward rate would simply suggest taking a position
via the forward or futures market. But if one’s expectation of volatility deviates from
the market, futures do not work any more, but options are needed. Indeed, currency
options provide the only convenient means of hedging or positioning “volatility
risk,” as their price is directly influenced by the outlook for a currency’s volatility:
the more volatile, the higher the price of the option.
Corporate uses of currency options vary widely. Some multinational companies
use options to hedge transaction exposures, that is, currency risk from transactions
that have already been booked as payables or receivables. Others use them as a shield
against currency risk of future transactions (economic exposure). If companies bid
for overseas contracts, they face what is called “contingent exposures,” a risk with
respect to unexpected currency changes that arises only in case the company wins the
contract. Still other companies try to bet against the market by taking a position with
respect to the direction of currency changes or the expectation of volatility. A general
obstacle to the use of options might still be the fact that the purchase of an option—
as opposed to futures and forwards which are just mutual agreements—has to be paid
for, thus drawing management’s attention to the employment of this financial instru-
ment and requiring justification of its usefulness. An attempt to hide or avoid outlays
for such option premiums leads treasury departments to adopt more risky strategies
that involve the simultaneous sale of an option—with the concomitant downside
risks.
6.8 CONCLUSION. This chapter offers the reader an introduction to the complex
subject of the measurement and management of foreign exchange risk. We began by
noting some problems with interpretation of the concept, and entered the debate as to
whether and why companies should devote active managerial resources to something
that is so difficult to define and measure.
Accountants’ efforts to put an objective value on a firm involved in international
business has led many to focus on the translated balance sheet as a target for hedg-
ing exposure. As was demonstrated, however, there are numerous realistic situations
where the economic effects of exchange differ from those predicted by the various
measures of translation exposure. In particular, we emphasized the distinctions be-
tween the currency of recording, the currency of denomination, and the currency of
determination of a business.
After giving some guidelines for the management of economic exposure, the chap-
ter addressed the thorny question of how to approach currency forecasting. We sug-
gested a market-based approach to international financial planning, and cast doubt on
the ability of the corporation’s treasury department to outperform the forward ex-
change rate.
The chapter then turned to the tools and techniques of hedging, contrasting the ap-
plications that require forwards, futures, money market hedging, and currency op-
tions. In Exhibit 6.11, we present a sketch of how a company may approach the ex-
change management task, based on the principles laid out in this chapter.
6.8 CONCLUSION 6 • 27