Econ 334- International Business
Foreign Exchange Risk and Hedging
Introduction
Foreign Exchange Risk
4
5
Transaction Exposure
5
Translation Exposure
6
Economic Exposure
7
Hedging
Conflict Between Exposures
Conclusion
References
8
9
10
11
Introduction
Currency has been used as a medium of exchange, for trading goods and services for around
10,000 years. It has evolved from food grains, to gold coins, to paper currency, and now plastic
money, i.e., credit cards. Money only works as a medium of exchange, since people who use it, and/
or accept it have assigned a value to it. Fiat currency1, especially have no real value to them since
they are unlimited, unlike gold or food grains, and therefore their value is nominal. And since every
country has their own currency, each one has its own nominal value.
Recent times have seen a surge in international trading; which in-turn has made it necessary to
assign values to exchange between each currency. This phenomenon is called Foreign Exchange.
Foreign Exchange markets are set up specifically for the purpose of trading in foreign currencies,
and therefore allow companies from different countries to enter into trade. This also allows
companies to set up subsidiaries in other countries.
But this inter-currency trade gives rise to Foreign Exchange Risk, which basically involves the
fluctuations in currency exchange rates, and its effect on forward contracts2. This risk subverts the
willingness of companies to trade, and operate in foreign lands, and for this reason, a great deal of
research has been done to circumvent situations of massive losses due to currency exchange
fluctuations.
Foreign Exchange Risk can expose the firm in broadly three different ways; Transaction
Exposure, Economic Exposure, and Translation Exposure. These financial risks will further be
discussed in latter sections of this paper.
Since international trade is extremely important for...