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Don't hesitate to comment below if you have any questions or additional phrases FX Risk ManagementTransaction Exposure Overview The three major foreign exchange exposures Foreign exchange transaction exposure Pros and cons of hedging foreign exchange transaction exposure Alternatives of managing significant transaction exposure Practices and concerns of foreign exchange risk management ,Foreign Exchange Exposure Types of foreign exchange exposure Transaction Exposure – measures changes in the value of outstanding financial obligations due to exchange rate changes Operating Exposure – also called economic exposure, measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates Translation Exposure – also called accounting exposure, is the changes in owner’s equity because of the need to “translate” financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements Tax Exposure – as a general rule only realized foreign losses are deductible for purposes of calculating income taxes ,Moment in time when exchange rate changes Operating exposure Accounting exposure Change in expected future cash flows arising from an unexpected change in exchange rates Changes in reported owners’ equity in consolidated financial statements caused by a change in exchange rates Transaction exposure Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates Time Foreign Exchange Exposure ,Why Hedge - the Pros & Cons Opponents of hedging give the following reasons: Shareholders are more capable of diversifying risk than the management of a firm Currency risk management does not increase the expected cash flows of a firm Management often conducts hedging activities that benefit management at the expense of shareholders Managers cannot outguess the market Management’s motivation to reduce variability is sometimes driven by accounting reasons Efficient market theorists believe that investors can see through the “accounting veil” and therefore have already factored the foreign exchange effect into a firm’s market valuation ,Why Hedge - the Pros & Cons Proponents of hedging give the following reasons: Reduction in the risk of future cash flows improves the planning capability of the firm Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum – avoiding bankruptcy costs Management has a comparative advantage over the individual investor in knowing the actual currency risk of the firm Markets are usually in disequilibirum because of structural and institutional imperfections Reduction in variability of income reduces a firm’s overall tax burden ,Why Hedge - the Pros & Cons Hedged Unhedged Net Cash Flow (NCF) NCF Expected Value, E(V) Hedging reduces the variability of expected cash flows about the mean of the distribution. This reduction of distribution variance is a reduction of risk, but who benefits from it. ,Measurement of Transaction Exposure Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely Purchasing or selling on credit goods or services when prices are stated in foreign currencies Borrowing or lending funds when repayment is to be made in a foreign currency Being a party to an unperformed forward contract and Otherwise acquiring assets or incurring liabilities denominated in foreign currencies ,Purchasing or Selling on Open Account Suppose Trident Corporation sells merchandise on open account to a Belgian buyer for €1,800,000 payable in 60 days Further assume that the spot rate is $0.9000/€ and Trident expects to exchange the euros for €1,800,000 x $0.9000/€ = $1,620,000 when payment is received (assuming no change in exchange rate) Transaction exposure arises because of the risk that Trid