When a company begins a transaction in a foreign currency, it accepts an economic risk due to fluctuating exchange rates. The globalization of the world economy and the devaluation of the U.S. dollar have allowed more American companies to enter the export/import markets. Additionally, many managers who previously avoided these markets are finding that international transactions can make their companies more competitive in marketing products and procuring parts and materials. As new companies are exposed to foreign exchange risk, managers will necessarily be concerned with the development of an effective hedging program. While the task of managing financial risks generally falls to the CFO or treasurer, it is often others in the accounting department who are asked to evaluate the bottom line impact of these risks.
Strategies for Controlling Foreign Exchange Risk
Participation in international markets may result in a foreign exchange risk known as transaction exposure. This risk occurs when a company has a payable (or receivable) denominated in a foreign currency (FC).
The risk lies in the fluctuation of the FC exchange rate. For example, if the FC appreciates before the liability is settled, the company has to pay more dollars to purchase the FC needed to settle this liability. As a result, the company will experience a foreign exchange loss. Conversely, a company with a liability position in a weakening FC will experience a foreign exchange gain between the date the liability is incurred and its settlement. Opposite relationships hold for net asset positions, which are denominated in an FC.
A variety of hedging strategies are available to assist managers in controlling such foreign transaction risks. These include pricing, settlement, forward contracts, leading and lagging, and netting.
The most fundamental of the strategies to control risk is pricing, or controlling the billing currency. Exchange risk is...