Managing Foreign Exchange Risk

Managing Foreign Exchange Risk

DOI: 10.4018/978-1-5225-7280-0.ch007

Abstract

This chapter discusses the method's application to foreign exchange risk management by elaborating how to use foreign exchange options for hedging the interest rate risk. The problem is to determine how many European Put options to purchase for optimal hedging of the foreign exchange risk: 1) Stochastic Optimisation is used to construct Efficient Frontier of optimal hedging strategies of the foreign exchange risk with minimal Standard Deviation; 2) Monte Carlo simulation is utilised to stochastically calculate and measure the Total Amount Hedged (US $), Variance, Standard Deviation and VAR of Efficient Frontier optimal hedging strategies; 3) Six Sigma process capability metrics are also stochastically calculated against desired specified target limits for Total Amount Hedged and associated VAR of Efficient Frontier optimal hedging strategies; 4) Simulation results are analysed and the optimal hedging strategy is selected based on the criteria of minimal VAR.
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Introduction

Foreign exchange risk is the risk of incurring losses due to fluctuations of exchange rates. The variations of earnings result from the indexation of revenues and charges to exchange rates, or from the changes of the values of assets and liabilities denominated in foreign currencies (translation risk).

An early article by Laurent (1981) reviews the literature on Foreign Exchange Risk Management (FERM) in the 1970s. A narrative view of FERM is taken and the author focusses on forecasting the exchange rate and measuring exposure to exchange risk. Available decision models for handling transaction and translation exposures are reviewed. The article conclusion identifies gaps in the existing literature and suggests directions for research to cover the gaps.

Bennett (1997) published a book intended primarily to help those who, as a result of their commercial activities, have to manage foreign currency risk. The emphasis of the book is on practical issues involved in managing currency risk. The author has been involved with corporate treasury management for almost two decades in a variety of organisations and roles including currency management. So, this book as widely applicable. This work is focused on currency management widely applicable fundamentals of exposure identification and management. In particular, it is useful for smaller companies that do not have the resources to run a sophisticated treasury function but still need to manage currency exposure efficiently.

Brown (2000) in his paper investigates the foreign exchange risk management program of HDG Inc., an industry leading manufacturer of durable equipment with sales in more than 50 countries. The analysis relies primarily on a three-month field study in the treasury of HDG. Precise examination of factors affecting why and how the firm manages its foreign exchange exposure are explored through the use of internal firm documents, discussions with managers, and data on 3110 foreign-exchange derivative transactions over a three-and-a-half-year period. Results indicate that several commonly cited reasons for corporate hedging are probably not the primary motivation for why HDG undertakes a risk management program. Instead, informational asymmetries, facilitation of internal contracting, and competitive pricing concerns seem to motivate hedging. How HDG hedges depends on accounting treatment, derivative market liquidity, foreign exchange volatility, exposure volatility, technical factors, and recent hedging outcomes.

A comprehensive guide to managing global financial risk was published by Homaifar (2004). From the balance of payment exposure to foreign exchange and interest rate risk, to credit derivatives and other exotic options, futures, and swaps for mitigating and transferring risk, this book provides a simple yet comprehensive analysis of complex derivatives pricing and their application in risk management. The risk posed by foreign exchange transactions stems from the volatility of the exchange rate, the volatility of the interest rates, and factors unique to individual companies which are interrelated. To protect and hedge against adverse currency and interest rate changes, multinational corporations need to take concrete steps for mitigating these risks. This book offers a thorough treatment of price, foreign currency, and interest rate risk management practices of multinational corporations in a dynamic global economy. It lays out the pros and cons of various hedging instruments, as well as the economic cost benefit analysis of alternative hedging vehicles. Written in a detailed yet user–friendly manner, this resource provides treasurers and other financial managers with the tools they need to manage their various exposures to credit, price, and foreign exchange risk.

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