Finance Managing Exchange Rate Risk Can Be Term Paper

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Finance

Managing exchange rate risk can be a daunting task for many international firms attempting to expand overseas, acquire new companies, or simply manage its cash flows. Globalization has created a dynamic environment in which competition can arise to disrupt entire industries. Aspects such as technology, pharmaceuticals, banking, and automobiles have all experienced rapid change as a result of globalization and the competitive forces that underline it. As a result, companies, particularly smaller firms, have a higher propensity to experience volatile earnings overtime. Aspects that impact one sector of the globe can have a residual impact on other areas of the individual firm or industry. Managing exchange rates is therefore a viable option for firms to reduce volatility in earnings while subsequently managing its cash flows from operations. Below, is a 5 step program which could be implemented by a firm attempting to manage its exchange rate risk after an acquisition.

The first step in the process of managing exchange rate risk is to forecast exchange rate movements. Proper forecasting will require analysis of various macro and micro economic conditions that could adversely impact exchange rates. For example, as evident in the global financial crisis in 2008, central bank tendencies to expand its monetary base could have an adverse impact on exchange rates. This is particularly true for countries who have traditionally had a very weak currency relative to other countries. For example, the expansion of the monetary base within the United States made the Yen, a relatively weak currency, stronger. As a result, Japanese exports were more expensive. This resulted in Japanese companies being less competitive in the global markets. If these companies properly hedged their risks however, the impact of monetary expansion would have been minimal.

Therefore, in regards to our acquisition, it will be necessary to forecast what percentage of revenues comes from particular portions of the world.

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Within this context, we can then be in a better position to hedge the exposure of certain currencies that are believes to depreciate relative to others. An analysis of the political, economic, monetary policies of the country will also be warranted. As mentioned briefly above, political unrest and activity can have a significant impact on the exchange rate.

The second step will be to identify the level of complexity that will be used in hedging exchange rate risks. In many instances, hedging exchange rates can be very complex if used improperly. The organization should therefore have an understanding of the risks associated with using various options such as currency derivatives to hedge its cash flows of the acquisition. Companies often use options, forwards, futures, and swaps to hedge their foreign currency exposure. A currency swap for example, is a viable option utilized by many companies around the world to hedge its currency exposure by making payments to each other in different currencies (Jorion, 1999).

In regards to the acquisition, once the political, interest rate, governmental, and economic risk have been adequately ascertained, it will be necessary to understand what the hedge intends to accomplish. Complex solutions are not necessary the most rewarding in regards to reducing currency risk.

The third step is to simulate results using financial techniques. This step will require a detailed understanding of the hedging strategies goal, outlined in step two. Depending on the complexity of the acquisition, and the Below is sample calculation for a currency swap, which is one of the more simply transactions that can be used to hedge foreign exchange risk of the acquisition.

Undoubtedly,….....

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