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Foreign Exchange Risk Management Essay

Foreign currency exchange risk is the additional riskiness or varience of a firm’s cash flows that may be attributed to currency fluctuations (Giddy, 1977, Brigham and Ehrhardt, 2005). Normally, foreign currency risk exists in three forms; translation, transaction and economic exposures. Foreign currency risk management involves taking decisions which aim at minimizing or eliminating the negative effects of currency fluctuations on balance sheet and income statement values, a firm’s receipts and payments arising out of current transactions, and on long term future cash flows of a firm. Creativity by managers and innovations in financial instruments have, over the years, made available to firms a number of avenues that can be followed in managing the impact of foreign currency rate fluctuations.

These avenues are known more commonly as hedging techniques. A hedge is a means of defence against possible loss. Hedging is the process of reducing exposure, and consists of a number of techniques intended to offset or minimize the exchange risk of loss on assets or liabilities which are denominated in a foreign currency. Some hedging techniques can be implemented within the firm, i.e. without involving any market-based financial instruments. These are known as internal hedging techniques. All other techniques necessitate taking recourse to market – based financial instruments. These are external hedging techniques.


This research was conducted mainly in the form of a survey. It captured individuals’ opinions and assessment of foreign currency risk management awareness, practices and competencies. In training institutions, assessment of foreign currency risk management training was made by appraising contents of course outlines. The objective of appraising course outlines was to gauge the adequacy of course syllabi in these institutions in preparing trained graduates who are able to function, among others, in the area of foreign currency risk management. The survey focused on firms and professionals within firms as well as recent graduates of the leading two business schools in Tanzania. Interviews were also held with bank officers with the specific interest of appraising the availability of products and services to mitigate the effect foreign currency risk on businesses. REFERENCES: Adler, M (1982)”Translation Methods and Operational Foreign Exchange Risk Management,” in G. Bergendahl (Ed) International Financial Management, Stockholm, Norsteds. REVIEW 2

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How is foreign exchange risk managed? An empirical study applied to two Swiss companies.


This paper investigates how two Swiss companies manage their foreign exchange risk and compares the results to theoretical findings and to previous empirical research. We find significant differences in the foreign exchange risk management policies, notably in the choice of the type of exposure to cover and in the hedging instruments used. Consistent with previous research, forwards and netting are the most used instruments and transaction exposure is the most managed foreign exchange risk. Surprisingly, translation and economic exposures are not well identified and managed mainly because firms believe it is unnecessary or too complex. Finally, firms hedge their exposure but never fully due to high cost of hedging. REFERENCES: Allayannis, G., and J. Weston, “The use of Foreign Currency Derievatives and Firm Market Value”, Review of Financial Studies 14, 14, 2001, 243-276.


This dissertation studies on-balance-sheet and off-balance-sheet foreign currency risk management of corporate firms and commercial banks. It is comprised of two essays. The first essay investigates what determines firms‟ foreign currency spot net asset positions, derivatives hedging and synthetic hedging positions. We build a model that anticipates a firm’s market timing in currency markets and credit markets according to the exchange-rate return and interest rate differential. Using a unique set of data containing complete foreign currency spot and derivatives positions of Korean exporting firms, we empirically find that currency position-squaring firms have significantly higher firm value. We also find evidence that these firms time the currency market when they manage their currency cash position. Meanwhile, firms time the credit market when they determine the use of foreign currency debts. Strikingly, firms still time the market even when they conduct derivatives hedging and synthetic hedging. Our findings are consistent with the market timing theory of capital structure.

The second essay examines what determines banks‟ exposure to foreign currency risks, their management of these risks, and the relationship to the probability of bank failures. Using a unique data set of Korean banks with detailed information on their foreign currency risk exposures and hedging positions, we find that banks‟ foreign currency position mismatches, maturity mismatches, and debt roll-over risks are significantly attributed to their dollar carry lending strategy, which is stimulated by market timing of corporate firms, short-maturity dollar borrowings, real estate market booms, and dollar interest rate tightening. We also find that banks‟ foreign currency exposures significantly increase their financial distress likelihood through dollar carry lending activities. Finally we show that, overall, banks that better match their foreign currency positions and maturities are rewarded with lower probabilities of financial distress.


Adler and Dumas (1985) demonstrate how to measure the economic exposure of firms‟ market prices to exchange-rate changes. They argue that the exposure may be captured by the regression coefficient when an asset‟s price is regressed on exchange rates. Also, Jorion (1990) and Allayannis and Ofek (1998) estimate the exchange-rate exposure from a regression model that includes market returns and exchange-rate returns to explain the variability of firms‟ stock returns. Existing literatures mostly use similar methodology to measure firms‟ exchange-rate exposures (e.g., Bodnar and Gentry (1993), He and Ng (1998), Bodnar, Dumas and Marston (2002), Kolari, Moorman and Sorescu (2008), and Aggarwal and Harper (2010)). We also use the method suggested by Allayannis and Ofek (1998) along with the Fama-MacBeth regression to measure firms‟ stock return sensitivity to exchange-rate return. However, since the market return may not fully capture all the effects on stock prices other than exchange-rate changes, the FX beta measured by the regression model may have limitations.

Even though the industry and regulatory bodies widely employ foreign currency positions to measure the effects of exchange-rate changes, the literature rarely analyzed the foreign currency positions. There are only a few studies that analyzed foreign currency positions. For instance, Grammatikos, Saunders and Swary (1986) analyze U.S. banks‟ foreign currency positions and Chamberlain, Howe and Popper (1997) attempt to measure U.S. banks‟ net foreign assets as the sum of foreign currency assets less foreign currency deposits. We could collect foreign currency position data on Korean firms so that we could extensively study those currency positions. The existing literatures also documents the incentives for a firm are hedging. Smith and Stulz (1985) argue that there exists a positive relation between managerial wealth invested in the firm and the use of derivatives. Also, they demonstrate that financial distress costs stimulate firms to hedge by reducing the variability of a firm’s cash flows.

Froot, Sharfstein and Stein (1993) formalize a general framework for analyzing corporate risk management. They document that if external sources of finance are more costly than internally generated funds, there will be a benefit to hedging. Geczy, Minton, and Schrand (1997) extensively examine the motivations of a firm’s use of currency derivatives. They document that firms with greater growth opportunities and tighter financial constraints are more likely to use currency derivatives. Also, they argue that firms with extensive exchange-rate exposure and economies of scale are more likely to use currency derivates. Nance, Smith, and Smithson (1993) use survey data on firms‟ use of foreign currency derivatives and document that firms that hedge have more growth options in their investment opportunity set. Allayannis and Weston (2001) examine the use of foreign currency derivatives and its potential impact on firm value using Tobin’s Q as a proxy for firm value.

They find a positive relation between firm value and the use of currency derivatives. Carter, Rogers and Simkins (2006) document that jet fuel hedging is positively related to airline firm value. Our findings are consistent with the previous literature in the sense that foreign currency spot position squaring firms (i.e., on-balance-sheet hedgers) have higher firm values and actively invest in research & development activities. However, contrary to those previous studies, Jin and Jorion (2006) find that hedging does not seem to affect market values of the U.S. oil and gas industry. In this regard, some literature documents that firms are actually timing the markets instead of hedging. Faulkender (2005) examines whether firms are hedging or timing the markets when they select the interest rate exposures of their new debt issuances.

He measures firm’s interest rate exposures by combining the initial exposure of newly issued debts with their use of interest rate swaps. He finds that the final interest rate exposure is largely driven by the firms‟ market timing, not by hedging intentions. Allayannis, Brown, and Klapper (2003) examine a firm’s choice between local and foreign currency debt using a data set of East Asian firms surrounding 1998 financial crisis. They find that the interest rate differentials between local currency and foreign currency are important determinants for debt use. Those papers focus on the determinants of local and foreign currency debts. This study extends their studies and investigates what determines currency assets, liabilities, and net asset positions, as well as derivatives hedging and synthetic hedging.


We first define a foreign currency position-squaring firm as a firm that holds the absolute value of the foreign currency spot net asset positions less than 2.5 percent of its total assets. The firms that have the absolute value of the foreign currency net asset position more than 2.5 percent of their total assets are defined as non-squaring firms. If a firm covers its currency net asset position with currency derivatives, the firm is classified as a currency derivatives-hedging firm. Otherwise, the firms are classified as non-hedging firms. Exchange-rate exposure is important because every firm’s stock price in an open economy is exposed to exchange-rate movements. Previous studies have defined a firm’s economic exposure to exchange-rate movements as the sensitivity of firm value to exchange-rate. Changes across states of nature (Adler and Dumas (1984) and Allayannis and Ofek (1998)). Specifically, the literature uses a firm’s stock-return sensitivity to exchange-rate changes in order to proxy for the firm’s exchange-rate exposure.

A firm’s income statement is directly affected by the holding of its currency net asset position in the form of currency transaction profit (loss) and currency translation profit (loss). If a firm’s currency net asset position is zero, the firm’s currency related profit (loss) is also zero. Therefore, investigating the determinants of the net asset currency positions is worthwhile. Before we find them, we focus on the firm’s foreign currency assets. Foreign currency assets just like local currency assets consist of currency cash and cash equivalents, marketable securities, trade receivables, and others. Then we look at foreign currency liabilities. Foreign currency liabilities comprise currency trade payables, debts, and others. We also examine whether corporate governance variables have effects on the likelihood of increasing synthetic hedging.

The existence of stock options, foreign equity listing, and largest shareholder’s shareholding are employed as governance variables. To conduct robustness tests using groups of different firms, we divide sample firms into two groups according to their foreign sales over total sales. The first group shows foreign sales less than 50 percent of their total sales and the second group exhibits foreign sales more than or equal to 50 percent of their total sales. The recent global financial crisis gives an opportunity to make a natural experiment. We compare firms‟ foreign currency positions in year-end 2007 (before the crisis) and those in year-end 2008 (in the middle of the crisis). We also compare firms‟ foreign currency positions in year-end 2008 to those in year-end 2009 (past the crisis).

REFERENCES: Allen, M., C. Rosenberg, C. Keller, B. Setser, and N. Roubini, 2002. “A Balance Sheet Approach to Financial Crisis”. IMF Working Paper WP/02/210.



The study empirically investigates the strategic foreign exchange risk management practice by Danish medium-sized non-financial, not-listed companies that are involved in international activities. The study shows that interaction between financial and operational hedges exists in the management of operating exposure and that operational and financial strategies are seen as complements to each other. The empirical results supported the hypothesis that the hedging strategies of the companies depend on their previously build flexibility.

Multinationality and foreign exposure were significant explanatory factors for the importance and application of various hedging strategies. On the aggregate level, the risk management objective of the companies and the involvement of both the operational and financial departments in the risk management were significant factors in explaining the importance and application of the operational hedging strategies. The size of the company exhibited significance in explaining the importance and application of the financial hedging means.


The empirical evidence on strategic management of operating exchange rate exposure presented in the financial literature is rather limited. Most of the empirical studies concerned with foreign exchange exposure risk management are devoted to the usage of the short-term financial hedging instruments and the topic of the involvement of strategic approaches to the foreign exchange risk management by companies is researched only marginally. The purpose of the present chapter is to comment on the scarce empirical research conducted on the interaction between financial and operational approaches to foreign exchange risk management and companies’ adoption of various real options strategies as a response to exchange rate changes. According to the results of one the most significant surveys within the field of risk management conducted by Bodnar et al. (1998) the majority of companies concentrate their risk management activities on the management of directly observable near term currency exposures. Only 12 % of the companies responded that they manage longer term exposures and 11% manage competitive exposure.

The goal of the conducted survey was to investigate derivative usage for the risk management purpose, despite that, they found indication that companies consider both financial and operational means for their risk management activities. 14% of the responding companies stated that they do not use derivatives because they can effectively manage their exposures by resorting to various operational approaches. The researchers, however, have not attempted to study those operational approaches more detailed and no empirical analysis has been performed on the factors that determine the company’s choice of hedging approaches. Furthermore, the study was conducted on a sample of large companies. As the result of a survey conducted among large British industrial multinational enterprises Joseph (2000) also came to the conclusion that the risk management of the majority of the companies is based on the usage of derivatives and the companies apply a limited number of operational strategies.

According to his results the choice of internal hedging techniques can be explained by the company’s degree of internalization, though in general a company’s specific characteristics serve as better explanatory factors for company’s choice of external techniques. The empirical evidence on strategic management of operating exchange rate exposure presented in the financial literature is rather limited. Most of the empirical studies concerned with foreign exchange exposure risk management are devoted to the usage of the short-term financial hedging instruments and the topic of the involvement of strategic approaches to the foreign exchange risk management by companies is researched only marginally. The purpose of the present chapter is to comment on the scarce empirical research conducted on the interaction between financial and operational approaches to foreign exchange risk management and companies’ adoption of various real options strategies as a response to exchange rate changes.

According to the results of one the most significant surveys within the field of risk management conducted by Bodnar et al. (1998) the majority of companies concentrate their risk management activities on the management of directly observable near term currency exposures. Only 12 % of the companies responded that they manage longer term exposures and 11% manage competitive exposure. The goal of the conducted survey was to investigate derivative usage for the risk management purpose, despite that, they found indication that companies consider both financial and operational means for their risk management activities. 14% of the responding companies stated that they do not use derivatives because they can effectively manage their exposures by resorting to various operational approaches. The researchers, however, have not attempted to study those operational approaches more detailed and no empirical analysis has been performed on the factors that determine the company’s choice of hedging approaches. Furthermore, the study was conducted on a sample of large companies.

As the result of a survey conducted among large British industrial multinational enterprises Joseph (2000) also came to the conclusion that the risk management of the majority of the companies is based on the usage of derivatives and the companies apply a limited number of operational strategies. According to his results the choice of internal hedging techniques can be explained by the company’s degree of internalization, though in general a company’s specific characteristics serve as better explanatory factors for company’s choice of external techniques. Rangan (1998) in his empirical analysis of the US, European and Japanese multinational manufacturing companies reached the conclusion that companies do shift production in response to the changes in exchange rates but these operational shifts are relatively modest.

However, the conclusion was made based on the analysis of the data on industry and country level and the results were not supported by the actual data from companies. Bradley and Moles (2002) investigated the degree to which non-financial companies in UK that are listed on the stock market use strategic approaches in their foreign exchange exposure management. Their survey results revealed that companies do undertake various real action strategies as shifting the country of their sourcing of inputs or changing their production location as the response to movements in exchange rates. However, in line with Rangan’s conclusions, only one third of the respondents in their study indicated that they shift productions and sourcing locations as a response to exchange rate changes, thus operational shifts are relatively modest. Additionally, they found that most of the companies at least to some degree attempt to match currency denomination of costs and revenues cash flows.

Besides, the companies also involve such strategic financial instrument as the choice of currency denomination of their foreign debt. Therefore their general conclusion is that the companies prefer to use a combination of the financial and operational approaches in their operating exposure risk management. Furthermore, they found the evidence that the degree of adopting strategic approaches will be higher for those companies that have a network of foreign subsidiaries and the degree of resorting to operational hedges is related to the extent of involving operational departments in the foreign exposure risk management. Allayannis et al. (2001) studied exchange rate exposure management strategies of 265 US multinational non-financial companies. According to their results a company can benefit only from supplementary usage of financial and operational hedging techniques.

However, this study was based on the information presented in the COMPUSTAT database and operational and financial strategies were proxied by several variables received from the financial reports available from the companies therefore the actual strategies of the companies were not investigated. Another empirical study of US multinationals by Pantzalis et al. (2001) revealed that operational hedges are significant for the management of foreign exchange risk. But this study was concerned with the impact of operational hedges on the foreign exchange exposure itself rather than with investigation of the operational strategies that are adopted by companies or factors that influence companies’ choices of operational hedges.

Similar to Pantzalis, Carter et. al. (2003) also examined the effect of both operational and financial hedging techniques on foreign exchange exposure. According to them, financial and operational strategies are effective mechanisms in case of both negative or positive exchange rate changes. Furthermore according to their regression results the hypothesis that operational hedging techniques can be considered as real options adopted by companies holds from two perspectives. First of all, the ability of the companies to adopt operational approaches to foreign exchange risk management is incorporated in the existing network of foreign subsidiaries of companies. Thus the companies that have no foreign subsidiaries do not possess those operational hedging options that the companies with the network of foreign subsidiaries do. Second of all, the companies that adopt operational hedges besides reducing their exposures to adverse currency movements have an option to receive extra profits from beneficial exchange rate positions.

In line with Allayannis et al. (2001), Pantzalis et. al. (2001), Carter et. al. (2003) in a similar empirical study Choi and Kim (2003) also examined currency exposures of US firms and found the evidence that interaction between operational and financial hedging exists. Marshall (2000) compared risk management practices among UK, USA and Asia Pacific multinational corporations. He found that companies in Asia Pacific adopt significantly different approaches to their foreign exchange exposure management than UK and US companies. He also found that for the management of operating exposure, pricing strategy was the most popular. The research conducted by Marshall was oriented on the identification of regional differences for the management of transaction and translation exposures, thus a limited amount of attention was paid to the strategies the companies used for the management of operating exposure. Driouchi et al.(2006) explored the relationship between the general performance of companies and their operational capabilities from the perspective of real options.

Though this study does not directly investigate foreign exchange risk management practice or exchange rate exposure of companies, it provided additional evidence that the companies that posses various real options operational capabilities incorporated in their international and operational flexibility can in general reduce risk and benefit from advantageous opportunities. In the empirical study by Faseruk and Mushara (2008) which focused on exchange risk management, the authors pointed on the value enhancing power of the combination of financial and operational foreign exchange risk management activities. According to their results, in those cases when companies jointly involve financial and operational hedges the market-to-book value of companies was increased by 14% and market value-to-sales by 40%.

The research however, was only addressed to the risk management practice of large Canadian non-financial companies and risk management activities were proxied by variables taken from the financial statements of the companies. Based on the sample of Danish companies two empirical studies shed some light on the strategic approaches of foreign exchange risk management by Danish companies. Kuhn (2007) investigated the risk management practice of Danish medium sized companies. Though his primary interest of the research was concerned with the usage of financial instruments, he found that about 25 % of the companies consider the usage of operational means in general as an important tool in managing foreign exchange risk.

Using a sample of Danish listed non-financial companies Aabo and Simkins (2005) found that interaction between financial and operational hedging techniques for foreign exchange risk management exists and companies do use real options strategies as the response to exchange rates changes. If taken individually, company-specific characteristics like the company’s size, export and the number of foreign subsidiaries failed to explain the company’s choice to undertake real options strategies. Only a combination of the mentioned characteristics was a statistically significant explanatory factor for the likelihood of adopting by companies real options strategies. The study, however, was focused on large listed companies and therefore the results cannot be transferred to the medium-sized companies. Furthermore, the authors have not analyzed the significance of the factors in explaining the companies’ choice between financial and operational hedges.

As it is seen from the mentioned above studies, most of the empirical research on the topic of interaction between financial and operational approaches to foreign exchange risk management is addressed to large companies and yet little attempt is made to study which strategies are important for the companies and to which extent those strategies are used. The results of all the studies, however, provide direct evidence that companies do manage foreign exchange exposure by applying strategic approaches and their application is a significant value enhancing activity for companies.


The empirical research conducted for the purpose of the thesis is designed to provide a “snapshot” of the strategic foreign exchange risk management practice of Danish medium-sized companies. In order to test a range of hypotheses presented in the academic and empirical literature on the topic and to answer the research questions cross-sectional data was utilized. A self-completion approach was applied to collect the data about the companies’ foreign exchange risk management practice. For this purpose a structured electronic survey was developed and delivered to the target group of respondent companies. Additional company specific data necessary for the research was obtained through the web-direct database. The following sections provide a description of the sampling process and survey design, administering and response. REFERENCES: Froot, K.A., Scharfstein, D. S. and Stein, J.C., 1994. “A framework for Risk Management”. Harvard Business Review, nov.-dec., pp. 91 – 102.


The gradual liberalization of Indian economy has resulted in substantial inflow of foreign capital into India. Simultaneously dismantling of trade barriers has also facilitated the integration of domestic economy with world economy. With the globalization of trade and relatively free movement of financial assets, risk management through derivatives products has become a necessity in India also, like in other developed and developing countries. As Indian businesses become more global in their approach, evolution of a broad based, active and liquid Forex (Foreign Exchange) derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures.

This research paper attempts to evaluate the various alternatives available to the Indian corporate for hedging financial risks. By studying the use of hedging instruments by major Indian firms from different sectors, the paper concludes that forwards and options are preferred as short term hedging instruments while swaps are preferred as long term hedging instruments. The high usage of forward contracts by Indian firms as compared to firms in other markets underscores the need for rupee futures in India. In addition, the paper also looks at the necessity of managing foreign currency risks, and looks at ways by which it is accomplished. A review of available literature results in the development of a framework for the risk management process design, and a compilation of the determinants of hedging decisions of firms.


Collier and Davis (1985) in their study about the organisation and practice of currency risk management by U.K. multi-national companies. The findings revealed that there is a degree of centralised control of group currency risk management and that formal exposure management policies existed. There was active management of currency transactions risk. The preference was for risk-averse policies, in that automatic policies of closeout were applied. Batten, Metlor and Wan (1992) focussed on foreign exchange risk management practice and product usage of large Australiabased firms. The results indicated that, of the 72 firms covered by the Study, 70% of the firms traded their foreign exchange exposures, acting as foreign exchange risk bearers, in an attempt to optimise company returns. Transaction exposure emerged as the most relevant exposure. Jesswein et al,(1993) in their study on use of derivatives by U.S. corporations, categorises foreign exchange risk management products under three generations: Forward contracts belonging to the First Generation;

Futures, Options, Futures- Options, Warranties and Swaps belonging to the Second Generation; and Range, Compound Options, Synthetic Products and Foreign Exchange Agreements belonging to the Third Generation. The findings of the Study showed that the use of the third generation products was generally less than that of the second-generation products, which was, in turn, less than the use of the first generation products. The use of these risk management products was generally not significantly related to the size of the company, but was significantly related to the company’s degree of international involvement. Phillips (1995) in his study focused on derivative securities and derivative contracts found that organisations of all sizes faced financial risk exposures, indicating a valuable opportunity for using risk management tools. The treasury professionals exhibited selectivity in their use of derivatives for risk management.

Howton and Perfect (1998) in their study examines the pattern of use of derivatives by a large number of U.S. firms and indicated that 60% of firms used some type of derivatives contract and only 36% of the randomly selected firms used derivatives. In both samples, over 90% of the interest rate contracts were swaps, while futures and forward contracts comprised over 80% of currency contracts. Hentschel and Kothari (2000) identify firms that use derivatives.

They compare the risk exposure of derivative users to that of nonusers. They find economically small differences in equity return volatility between derivative users and nonusers. They also find that currency hedging has little effect on the currency exposure of firms’ equity, even though derivatives use ranges from 0.6% to 64.2% of the firm’s assets. Our findings are very important since no previous work has examined the FERM practice in Indian context. This study will be a pioneering attempt in Indian scenario and first of its kind to survey the Indian companies and their risk management practices.


An exploratory survey, by way of extensive literature review of books, journals and other published data related to the focus of the study, as also concerned websites, was carried out to gather background information about the general nature of the research problem.

1. Sources of Data

The main part of the Study deals with Indian corporate enterprises’ awareness of and attitudes to foreign exchange risk exposure. The required data was collected through the pre-tested questionnaire administered on a judgement sample of 500 corporate enterprises, located in different parts of the country. The administration of the questionnaire was done through multiple channels, which included surface mail, e-mail and personal involvement. Information relating to contemporary practices abroad was obtained from published sources such as journals, reports, and from related websites.

2. Sample for the Study

The survey was accomplished with the pre-tested questionnaire administered on 500 corporate enterprises in India (banks and subsidiaries of foreign multi-nationals not included), having foreign exchange exposure. A combination of simple random and judgement sampling was used for selecting the corporate enterprises for the exploratory Study. As against the 850 questionnaires circulated, 588 responses were received. Of these, 37 had to be eliminated, as they were incomplete in many respects. The respondents are spread over 18 different major industry classifications. The sample covers both old economy corporate like Manufacturing, Minerals, Trade, Oil etc., and new economy corporate including Information Technology (IT), Information Technology Enabled Services (ITES), Business Process Outsourcing (BPO) etc., and they vary notably in size.

The respondents to the questionnaire are financial executives with responsibility for FERM and for hedging foreign exchange risk exposure by use of derivatives. The Study is exploratory in nature and aims at an understanding of the risk appetite and FERM practices of Indian corporate enterprises. It also embraces an understanding of the policy or other constraints or impediments faced by the enterprises in managing foreign exchange exposure. The Study has its focus on the activity of end users of derivatives and, hence, is confined to nonbanking corporate enterprises.

Since banks both use and sell derivatives, they have not been included in the scope of the Study. Risk management practices of Indian subsidiaries of MNCs are determined by their parent companies and, hence, they do not form part of this Study. In analysing the responses, the Microsoft Excel Spreadsheet and the Statistical Package for Social Sciences (SPSS) have been used. Factor Analysis, using Principal Component Method, was done wherever there was need to reduce variables into factors. Correlation analysis was also done, as needed.

REFERENCES: Muller and Verschoor, March, 2005, The Impact of Corporate Derivative Usage on Foreign Exchange Risk Exposure, Available at http://ssrn.com/abstract=676012


Using a case study approach, this paper reviews the corporate exchange risk management practices of a single large UK multinational company. The research results shed new light on the management of economic exchange rate risk and also have implications for the effects of movements in exchange rates in the context of the translation process. More generally, these results indicate that, instances in which corporate practices deviate from normative prescriptions do not necessarily imply sub-optimal behaviour, although some companies may benefit from the re-consideration of their exchange risk management policies. Finally, they highlight new areas of research and also emphasise the role of qualitative research in accounting and finance.


This section covers the theoretical aspects of, and prior research on, the three forms of exchange rate risk: translation, transaction and economic risk. Consistent with Lessard (1989) and Dhanani and Groves (2001), the term exchange risk here refers to situations in which movements in exchange rates alter the financial performance of firms as measured by conventional financial statements and/or corporate cash flows. This terminology differs from that of Adler and Dumas (1984), who distinguished between currency risk and currency exposure. The authors used the term risk to refer to the volatility of exchange rates without any specific implications for firms, while exposure referred to the actual change in a firm’s financial performance as a result of a movement in a rate of exchange.

The Adler and Dumas (1984) classification system is less commonly used in the exchange risk management literature and, more importantly, the distinction adds little value to this paper, since the case firm itself does not differentiate between risk and exposure. Translation exchange risk is a result of the restatement of financial statements of foreign subsidiaries into parent currency terms for the purposes of consolidation. The process of translation, together with movements in exchange rates, may give rise to translation gains or losses in the annual accounts as firms seek to arrive at a ‘balanced’ balance sheet; these gains and losses have conventionally been termed translation risk.

Statement of Standard Accounting Practice (SSAP) 20, ‘Foreign Currency Translation’ (Accounting Standards Board, 1983), currently operational in the UK, requires firms to use the closing (or current) rate method of translation. Here foreign currency denominated assets and liabilities are translated at the rate of exchange ruling at the balance sheet date (i.e. the ‘closing’ rate), while the profit and loss account is translated either at the average rate of exchange for the financial year or at the closing rate. Share capital is translated at the rate of exchange ruling at the date when it was first issued (historic rate). The resulting translation gains and losses are reported as a separate component of shareholders’ equity and bypass the income statement.

SSAP 20 mirrors Statement of Financial Accounting Standards (SFAS) 52 (Financial Accounting Standards Board, 1981) of the US, although the American standard prefers use of the closing rate of exchange for the translation of the profit and loss account. SFAS 52 replaced SFAS 8 (Financial Accounting Standards Board, 1975), which was based on the temporal method of translation. This method sought to preserve the accounting principles used to value assets and liabilities in the original financial statements and, accordingly, used historic rates to translate items stated at historic cost and the closing rate for items stated at replacement cost, market value or expected future value. The resulting translation gains and losses were taken immediately to the income statement, to reflect the changes in the values of the assets and liabilities, as quoted in parent currency terms.

The general consensus amongst academics in finance is that corporate managers should not manage their translation exchange risk since it is concerned with the external reporting of past events and does not have any meaningful implications for the future cash flows and, in turn, for the market values of firms (Dufey, 1972; Srinivasulu, 1983). Moreover, use of strategies such as the currency denomination of debt and currency derivatives to manage the risk may create an adverse effect on corporate market value (Asiamoney, 2001). For example, derivative usage to create balance sheet certainty simply transfers volatility from the balance sheet to the firm’s cash flows since the hedge creates a cash asset (or liability) for which there is no opposing cash based match. In contrast to the theoretical prescription, however, earlier US based empirical research into the management of exchange risk, reported that translation risk formed the centrepiece of most firms’ risk management policy (Rodriguez, 1980).

Translation gains and losses often had very pronounced effects on the overall reported profitability of firms; effects which, in some instances, were even more significant than those caused by the operational activities of firms (such as the level of sales and profit margins) (Eitemann et al., 2000). Research into the capital market impact of FASB 8 indicated that investors, too, were responsive to translation risk as reflected in annual income statements (Ziebartand Kim, 1987; Satlaka, 1989). Following the replacement of FASB 8 with SFAS 52, translation risk became less relevant to American firms since it no longer affected corporate income levels (Choi et al., 1978). Moreover, capital market investors also became less concerned with the risk (Ziebart and Kim, 1987; Satlaka, 1989) and firms in turn shifted their attention to the management of transaction risk (Khoury and Chan, 1988).

Following the introduction of SSAP 20 in 1983, UK firms also mirrored the pattern of American firms and emphasised the role of transaction risk in their overall risk management programmes (Belk and Glaum, 1990; Davis et al., 1991). While MNCs, in general, pay little attention to conventional translation risk, prior interview research suggests that movements in exchange rates in the context of the translation process, nonetheless, have important corporate implications on two, separate accounts. First, they may adversely alter firms’ gearing ratios as quoted in parent currency terms since the rates of exchange used to translate the individual elements of the ratios may differ, year on year (Walsh, 1986; Davis et al., 1991). This is of particular concern to firms who use their gearing ratios for funding arrangements since they fear breach of loan covenants because of movements in exchange rates. The primary manner in which firms seek to manage this risk is by matching the currency of their debt portfolios with those of their foreign assets with a view to attaining the target gearing ratio in each of the currencies that concern them.

Second, movements in exchange rates may give rise to what Davis et al. (1991) identified and termed ‘translation profit and loss exchange risk’. Here the ‘risk’ does not materialise as a specific gain or loss in the financial statements; rather it represents a change in the actual level of earnings reported in parent currency terms to that reported in the previous period or from that budgeted (expected) by the company (investors), as a result of movements in the rates of translation. Here corporate concerns, as Brown (2001) examined, stem from concerns over investor perceptions and agency issues.

Reviewing the risk management practices of an American manufacturer, HDG plc, Brown (2001) noted that senior managers at the firm acknowledged and managed their translation profit and loss risk since they believed that the volatility in ‘reported accounting numbers’ resulting from movements in exchange rates, would have an adverse effect on share price since the market penalises lower than expected earnings more than it rewards higher than expected earnings. More generally, the firm also believed that analysts expected the company to manage the impact of foreign exchange on earnings and, consequently, sought to do so. Indeed, analysts following the firm confirmed these views, by acknowledging the importance of smooth earnings through the management of currency effects. Aabo (2001), in his research into exchange risk management at Danish firms, reported that the most important way in which firms expected hedging to add value was through reducing corporate stakeholders’ perceived risks of movements in exchange rates.

The risk management policy at HDG plc also had implications for ‘efficiency gains through improved internal…evaluation [of corporate managers]’ (p. 402). The basic notion here was that if the firm were not to hedge its translation risk, well performing managers would be penalised in parent currency terms by adverse changes in exchange rates over which they had no control. The performance of a foreign subsidiary manager, for example, would be undermined in the event that the local currency depreciated against the parent currency. Indeed senior managers at HDG plc were under pressure to attain hedge rates as constant as possible and as favourable as possible to stabilise and even better the performance of overseas subsidiaries. Overall the risk approach adopted here was considered to manage potential motivational issues, which were, in turn, considered to have positive implications for the firm as a whole.

Transaction exchange risk, the second form of exchange risk, is a cash flow risk that materialises when companies seek to convert their committed foreign currency cash flows into home currency terms, and the rates of exchange at the date of conversion are not known with certainty. For most MNCs, this is the most obvious and easily identifiable form of exchange rate risk. Finance literature encourages the management of this risk, since it has direct cash flow and in turn market value implications for firms (Srinivasulu, 1983). Firms may use financial instruments or other strategies that mirror these instruments, such as money market hedges, to manage their transaction risk. Here, the tools fix the rates of exchange for the dates that companies are concerned with. Alternatively, firms may employ internal measures such as leading or lagging payments and receipts, which serve to reduce their overall exposure levels.

The organisational structure of transaction risk management has also been a primary consideration in the literature. A centralised treasury function is deemed to be the most effective means of controlling, co-ordinating and managing currency exposures (Ankrom, 1974; Collier and Davis, 1985), although some researchers have argued that it may result in a loss of initiative and motivation for managers operating in otherwise autonomous subsidiaries (Lee et al., 2001). Obvious advantages of a centralised function include the opportunities to net subsidiary exposures, attain economies of scale in large transactions, and also pool and share the inevitably limited resources of expertise and experience in risk management. Centralisation may also encourage treasury personnel to develop specialised risk management skills. Prior research into the management of transaction risk, in the UK and elsewhere, indicates that this risk forms the centre-piece of most firms’ risk management programmes, with firms pursuing formalised policies with documented objectives, operating and reporting procedures.

Treasury managers are, in general, asymmetrically risk averse, although some firms seek to profit from their foreign exchange transactions. Such firms have specialist personnel to trade in the foreign exchange markets (Belk and Glaum, 1990). With regards to risk management strategies employed, although firms use some internal measures, financial instruments are a more popular choice. Amongst these, forward contracts dominate due to their relatively low costs, inherent flexibility and ease of organisation (Duangploy et al., 1997). Innovative instruments such as option contracts, although used, are less common since senior management are hesitant with such instruments in the light of their speculative nature, high up-front premiums and resource intensity (Belk and Glaum, 1992). Prior research also indicates that MNCs, in the UK and elsewhere, exhibit a strong tendency towards centralisation (Lee et al., 2001), although there are some important inter-firm differences in the location of policy formulation and implementation (Belk and Glaum, 1990; Collier and Davis, 1985).

In the case of policy formulation, at one extreme, a small proportion of UK firms fully centralise their formulation processes, and at the other, subsidiary managers are wholly responsible for their risk management decisions. In between, the central treasury provide subsidiaries with firm guidelines within which to operate. Where subsidiaries are involved with some aspect of policy formulation, and policy implementation is centralised, central treasury departments operate as ‘in-house ‘banks, with which subsidiaries hedge their exposures. This system allows firms to reap the benefits of netting opportunities, scale economies etc. while maintaining subsidiary autonomy, where warranted, to prevent adverse motivational effects. To add to the complexity of organisational structure, the level of centralisation appears to vary significantly between domestic and foreign subsidiaries, with the latter group experiencing more latitude than their sister subsidiaries in the home country (Collier and Davis, 1985; Belk and Glaum, 1990; Lee et al., 2001).

Economic exchange rate risk is concerned with the effect of long-term movements in exchange rates on firms’ expected future cash flows and, in turn, their overall market values. Unsurprisingly, it has been termed the most important form of exchange risk (Belk and Glaum, 1990; Miller and Reuer, 1998). While economic risk is sometimes considered to be an extension of transaction exchange risk, in that it extends to cash flows that have yet to materialise, it differs from transaction risk in one fundamental manner. Long term movements in exchange rates may have a more profound effect on the future cash flows since they can actually alter the firms’ abilities to generate those cash flows by influencing their level of sales, prices and input costs. Firms’ overall values are threatened to the extent that the exchange rate related changes to cash flows are not offset by corresponding changes to the prices of goods (inflation). In other words, economic exchange risk is a function of movements in real rates of exchange.

A multitude of factors, including the international locations of a firm’s plants, competitors, key buyers and suppliers, are considered to be important when assessing a firm’s economic exchange rate risk (Lessard, 1989; Miller and Reuer, 1998). A firm that operates in a different currency zone to that of a competitor, for example, may have to compromise on the level of sales and/or product prices in the event that favourable movements in exchange rates materialise for the competitor who may respond by offering customers discounted prices, something the firm itself is not in a position to do (Lessard, 1989). At the same time, a firm that relies on foreign suppliers may have the effects of adverse currency movements passed through, if the suppliers are in a position to do so without losing out to competition (Miller and Reuer, 1998). Economic exchange risk is difficult to measure and manage since it is a function of a multitude of factors.

Notwithstanding the innovative and sophisticated nature of currency derivatives available today, conventional financial hedging, in which firms forecast future foreign currency cash flows to hedge them in the foreign exchange markets, serves little purpose to protect firms from economic risk. The approach is intrinsically flawed since it does not seek to manage changes in actual cash flows as caused by movements in exchange rates; rather it focuses only on the conversion/nominal aspects of exchange risk. Moreover, it may actually be counterproductive in that it may initiate economic risk where none existed (Belk and Glaum, 1990). Financial hedges may lock firms into particular rates of exchange and if actual spot rates happen to be more favourable, these firms may be at a disadvantage as compared to their unhedged competitors, who are in a position to reduce their product prices in an attempt to increase their market share.

Since its inception, two theoretical frameworks, a qualitative and a quantitative framework, have been developed to measure and manage economic exchange risk. The qualitative approach views economic risk as a business risk, rather than a financial one, since it affects the strategic (competitive) profile of firms (Lessard, 1989; Dhanani and Groves, 2001). The approach here contends the use of operational adjustments such as procurement and marketing mix changes to manage the risk. Such adjustments alter the currency mix of firms’ revenues and costs and, as a result, accommodate the effects of movements in exchange rates. An exporting firm may, for example, source some of its input materials from the foreign markets in which it sells. Thus, the reduction in the level of revenues from these markets as a result of a home currency revaluation will be offset by a corresponding reduction in the level of operating costs. Alternatively, the firm may alter the nature of its product or selling strategy or even target new, less competitive markets to influence its overall level of sales.

Other operational strategies include: establishing new production sites, or relocating production within existing sites to avoid the adverse effects of less favourable rates, and production rationalisation strategies which absorb the adverse currency effects. Overall the qualitative framework categorises the management of economic exchange risk as a general management issue, one that involves various organisational factors and not merely a technical issue to be left to foreign exchange specialists. In contrast, the quantitative framework measures economic risk with statistical regression techniques and emphasises the role of financial instruments to manage the risk (Adler and Dumas, 1984; Kanas, 1996). Both the measurement and the management processes here are confined to treasury departments and require little involvement from other corporate departments. The basic tenet of the measurement process is to determine the sensitivity of a company’s market value to movements in exchange rates using regression techniques: while exchange rates here comprise the independent variables, corporate market value, measured by proxies such as stock market prices (Aabo, 2001), is the dependent variable.

The resulting coefficients that reflect the firm’s sensitivity to exchange rate movements can then be used to determine the exposure levels in monetary terms based on specific, forecasted exchange rates and predicted future cash flows. For example, a firm with a future annual cash flow of £100,000 and an exposure level of 0.6 to a particular currency will experience a cash reduction of 6%, i.e. £6000, when the currency depreciates by 10%. The basis of the risk management strategy here is to use financial instruments to generate sufficient gains at maturity to compensate for the predicted reduction in the firm’s cash levels (£6000) at the forecast rate of exchange (10% depreciation).

Results from earlier studies on economic exchange risk indicated that many firms, in the UK and elsewhere, either did little to manage their economic risk or used strategies that deviated significantly from those prescribed in the theoretical literature (Belk and Glaum, 1990; Belk and Edelshain, 1997). Articles by corporate practitioners, (Lewent and Kearney, 1990; Maloney, 1990) and more recent research, however, show some support for the management of economic risk (Dhanani and Groves, 2001; Kim and McElreath, 2001). While results of academic research support the qualitative framework, practitioners, (Lewent and Kearney, 1990; Maloney, 1990) discussed the role of option contracts and a statistical model at their pharmaceutical and mining companies, respectively. Practices at neither firm, however, complied with the quantitative framework developed in the academic literature.

The purpose of this research is to examine the risk management practices of a large UK MNC, ABC plc, with emphasis on how and why it pursues its practices in the way it does. Of particular importance are issues relating to translation and economic exchange risk, since these are the two areas where there appear to be significant discrepancies between theory and practice and/or between practices at individual firms. Aspects of transaction risk, where appropriate, are also considered. The case firm in Maloney’s (1990) paper, WHCH plc, like ABC plc, operated in the mining industry like ABC plc, and although there are some aspects of the processes that are similar, there are other issues that are not covered by Maloney (1990) or are actually dissimilar. Moreover, a review of the practices in an academic context, which the Maloney paper lacks, adds further rigour to the current study and serves to inform future practice, research and theoretical development.


The primary purpose of this research was to examine and explain the risk management processes in a multinational company. The case study approach was considered appropriate since it lends itself to reviewing processes and seeking new insights and explanations for particular phenomena (Eisenhardt, 1989; Yin, 1994). This was especially important, because of the focus on economic exchange risk, the more subtle form of risk, which may have entailed complex processes. For example, the management process may have involved various operational departments (Lessard, 1989), for which the case approach was able to capture the views and practices of the different departments. Further, the qualitative approach permits the understanding of management decisions and actions in their own organisational settings (Tomkins and Groves, 1983; Dhanani and Groves, 2001), which proved invaluable here since the nature of the industry in which the firm operated helped, explain various aspects of the firm’s risk management practice.

ABC plc was selected as a suitable case based on ‘opportunity and convenience’ (Jorgenson, 1989); the researcher had access to senior management within it and, more importantly, the firm encountered extensive exchange rate risk. In light of the nature of its global operations and overall industrial structure, ABC plc was exposed to all three commonly identified forms of exchange rate risk. At the selection stage, the researcher used annual reports and specialist trade press to determine the extent to which ABC plc was likely to suffer from exchange rate risk and later verified this with the management at the firm. The field research consisted primarily of semi-structured interviews with corporate personnel and documentary analysis, both internal company documents and publicly available information. Interviews were conducted with the treasurer, assistant treasurer, risk management manager and the senior economist.5 Respondents were asked to describe their risk management approach at the start of their interview and the researcher sought further elaboration and/or clarification as and when necessary.

A framework developed from previous theoretical and empirical literature was used as a guide for the interview process to ensure coverage of all relevant issues. The data collected was analysed largely using procedures set out by Yin (1994) and Miles and Huberman (1994). These included the transcription of tape-recorded interviews, familiarisation with the case and reflection and analysis, including linking, of the content. The method of inquiry adopted in this study is not without its limitations. First, the reliability of case research has been questioned since researchers have considerable latitude to introduce bias in the data collection process and the issue of reflexivity is also enhanced as a result of personal contact between the researcher and interviewee. A key note with regard to the former issue is that some subjectivity on the part of the researcher was actually warranted to clarify issues such as inconsistencies observed between practices at ABC plc and normative theory.

With regards to reflexivity, the description of the risk management process provided by the interviewees at the start of the meetings bound them to specific themes and values, which they were unlikely to alter on further questioning. Further, triangulation between the different sources of data collection also served to reduce respondent bias. Second, case research has often been criticised as having limited scope for generalisation of results. A critical point to note here, however, is that the richness and depth attained in case study research compensate for the lack of generalisability. This is so especially, if the case validates the results of prior research, or identifies areas for future development of theory and/or practice. Further, as this study shows, there may be limited scope for generalisation, since the organisational context of firms, in particular, the nature of the industries that they operate in, appears to shape their exchange risk management practices. REFERENCES: Aabo, T., 2001. Exchange rate exposures and strategies of industrial companies: an empirical study. Thunderbird International Business Review, 379–395.


Foreign currency exchange management is very crucial in firms with foreign deals. The objective of this research was to study the management practices in Jordanian firms of foreign exchange management and its risk on these firms. A questionnaire was used to collect data using a stratified random sample. The results show that the firms interested with foreign currency exchange management as it forms more that 50% of its deals. Most of firms indicated that they have a policy for foreign exchange risk management depends on history records of exchange rate of JOD for US dollar.


Belk & Glaum (1990) studied the “THE MANAGEMENT OF FOREIGN EXCHANGE RISK IN UK MULTINATIONALS: AN EMPIRICAL INVESTIGATION”. The study is based upon research conducted in 17 major UK industrial companies during 1988. These companies were selected because of their significant degree of international involvement. Personal interviews were conducted with senior financial managers (normally treasurers) who were asked about their companies’ foreign exchange risk management. The scope of the research was concerned with: accounting exposure management; transaction exposure management; economic exposure management; the organization of the companies’ foreign exchange risk management; and objectives of such management. Research found that the majority of the companies were managing their accounting exposure despite of the financial literature that demonstrate accounting exposure as not useful for foreign exchange risk management, in addition, the majority considered transaction exposure was the centrepiece of their foreign exchange risk management.

Heterogeneous results were produced in the economic exposure management due to the complex nature of that topic and the diversity of the companies, also, a large majority of the companies studied had centralized their foreign exchange risk management and the majority of the interviewees described their companies as “totally risk averse”, although they aim profit from foreign exchange management and did not hedge all of their exposures, a small minority characterized their companies attitudes as “risk takers”. Batten, et al. (1993) studied FOREIGN RISK MANAGEMENT PRACTICES AND PRODUCTS USED BY AUSTRALIAN FIRMS” concentrates on foreign exchange risk management practice and product usage of large Australian-based firms; results are discussed from an empirical field study of 72 firms operating in Australia. The research was conducted using data from mail questionnaire sent to 500 firms selected randomly from 3508 public and private firms with sales over A$10 million per annum.

The survey analysis was undertaken in two stages, initially, descriptive analysis of a number of company characteristics and management practice variables, then based on a statistical analysis of five firm-specific variables with sex management-practice variables. Results of the study were concerned by these issues: The extent to which industry actively manages rather than hedges FX risk, which suggested that (70%) trade their foreign exchange exposure. How firms determine foreign exchange risk, consistent with Belk & Glaum (1990), most of the sample firms identified transaction exposure as being the most relevant. Also few respondents measured economic exposure. Also very few (8.3%) respondents manage both transactions and translation risk. The described what techniques were favoured by the sample firms. The study also provided insight into which characteristics of a firm in general had the major impact on the risk management practices of the firm, which was the firm size measured by the foreign exchange turn over. Also the form of ownership (foreign or domestic) had an important impact on the degree of centralization of the treasury management function as does the legal structure of the firm (public or private).

Yan & Brucaite (2000) studied the “Financial Risk Management: Case Studies with SKF and Elof Hansson” a case study was conducted to investigate how theoretical transaction exposure management is executed in practice. An analysis of the transaction exposure management of two multinational companies from different industrial clusters as a descriptive example was made. Data was collected using interviews with persons responsible for the management of foreign exchange risk in these two firms, the researchers put firms real business transaction into the theoretical transaction life span and tried to find out if, in reality, the companies use the transaction exposure management as the theory suggests. Finally, financial risk management strategies of both companies were compared. The study concluded that there is no general transaction exposure management rule that could be applicable to all the companies. Every company has its own specific characteristic, which depends on a lot of different macroeconomic factors. The comparison of the companies’ transaction management strategies provided the companies with the exceptional opportunity to get a clear and detailed picture of the other company’s transaction management strategy. Such information is usually not publicly announced.

Fang & Miller (2004) studied the “EXCHANGE RATE DEPRECIATION AND EXPORTS: THE CASE OF SINGAPORE” revisits the weak relationship between exchange rate depreciation and exports for Singapore, Previous research that investigated the responsiveness of exports to exchange rate depreciation generally concluded that exports react increasingly to exchange rate depreciation. To provide evidence, the study used bilateral exports between Singapore and the U.S. on a monthly basis from January 1979 to October 2002. Seasonally adjusted real export revenue equals nominal export revenue in domestic currency deflated by the consumer price index (CPI). Research converted the bilateral nominal exchange rate, defined as the Singaporean currency price of the U.S. dollar, into a real exchange rate by multiplying the nominal rate by the ratio of the U.S. CPI to the Singaporean CPI.

Foreign income equals US industrial production with base year 1995. All data came from the International Financial Statistics and Direction of Trade of the IMF. The study employed bivariate GARCH-M modelling technique to estimate the effects of exchange rate depreciation and its risk on exports. Results found that the effect of exchange rate depreciation on exports is positive but insignificant, supporting the findings of Abeysinghe and Yeok’s (1998). Second, time varying real exchange rate risk exhibits a significant negative effect on exports of substantial magnitude. Third, the exchange rate risk effect dominates the depreciation effect in magnitude, leading to a negative net effect of exchange rate changes on export revenue.


Sample of 120 Jordanian enterprises were selected using stratified random sample. The methodology of this sampling technique was used to select different sizes of enterprises to get comprehensive image about the procedures used by them to deal with foreign exchange risk issues. Due date to return the questionnaire, if not already done. Respondents targeted were mainly financial managers and/or treasurers. REFERENCES: Garbaccio, R, Ho, MS, Jorgenson, DW, (2000). A Dynamic Economy-Envrionment Model of China.Version 2.Kennedy School of Government, Harvard University, Cambridge.


In the period of crisis the volatility of foreign exchange is one of most important elements to be consider in the risk management strategy at corporate level .The paper will focus on the main types of foreign exchange exposure, the role of hedging in managing the currency risk and the measurement of transaction exposure. The risk management in practice is illustrated by a case study designed to capture and contrast the effects of different types of options for hedging the transaction exposure.


Reviewing the relevant literature on the subject some points should be retained as the starting point of the current approach (Moffett, 2009). In analyzing the foreign exchange exposure three types of foreign exchange exposure should be considered:

Transaction exposure is the potential for a gain or loss in contracted-for near term cash flows caused by a foreign exchange rate-induced change in the value of amounts due to the multinational2 companies or amounts that the multinational companies owes to other parties. As such, it is a change in the home currency value of cash flows that are already contracted for. Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. Thus, this type of exposure deals with changes in cash flows the result from existing contractual obligations.

Operating exposure, also called economic exposure, competitive exposure, or strategic exposure, measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates. The same it refers to a change in expected long-term cash flows; i.e., future cash flows expected in the course of normal business but not yet contracted for.

Translation exposure is the possibility of a change in the equity section (common stock, retained earnings, and equity reserves) of a multinational company’s consolidated balance sheet, caused by a change (expected or not expected) in foreign exchange rates. As such it is not a cash flow change, but is rather the result of consolidating into one parent company’s financial statement the individual financial statements of related subsidiaries and affiliates. Multinational companies possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices. These three financial price risks are the subject of the growing field of financial risk management. Many firms attempt to manage their currency exposures through hedging. Hedging the currency risk is an important pillar of the general risk management of a multinational company. In general terms, hedging is the taking of a position, either acquiring a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position.

Hedging therefore protects the owner of the existing asset from loss. However it also eliminates any gain from an increase in the value of the asset hedged against. The value of a firm, according to financial theory, is the net present value of all expected future cash flows. The fact that these cash flows are expected emphasizes that nothing about the future is certain. The fact that the future cash flows are affecting the value of the company the efforts to limit the alteration of those flows by the exchange rate change is of great importance. Currency risk, on focus in a hedging consisting strategy, is seen as the variance in expected cash flows arising from exchange rate changes. A firm that hedges these exposures reduces the variability of its future expected cash flows about the mean of distribution. This reduction of distribution variance is a reduction of risk.


As methodology, in building a currency risk management, we started from taking into account the arguments pro and cons for an active currency risk management program. The six arguments against a firm pursuing an active currency risk management program are (Stulz, 1996): (1) Currency risk management does not increase the expected cash flows of the firm. (2) Currency risk management normally consumes some of a firm’s resources and so reduces cash flow. The impact on value is a combination of the reduction of cash flow (which by itself lowers value) and the reduction in variance (which by itself increases value). (3) Management often conducts hedging activities that benefit management at the expense of the shareholders. The field of finance called agency theory frequently argues that management is generally more risk-averse than shareholders. If the firm’s goal is to maximize shareholder wealth, then hedging activity is probably not in the best interest of the shareholders. (4) Managers cannot outguess the market.
If and when markets are in equilibrium with respect to parity conditions, the expected net present value of hedging is zero. (5) Management’s motivation to reduce variability is sometimes driven by accounting reasons.

Management may believe that it will be criticized more severely for incurring foreign exchange losses in its financial statements than for incurring similar or even higher cash costs in avoiding the foreign exchange loss. Foreign exchange losses appear in the income statement as a highly visible separate line item or as a footnote, but the higher costs of protection are buried in operating or interest expenses. (6) 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. Four arguments are to be considered in favour of a firm pursuing an active currency risk management program (Bodnar, 1998): (1) Reduction in risk in future cash flows improves the planning capability of the firm. If the firm can more accurately predict future cash flows, it may be able to undertake specific investments or activities that it might otherwise not consider. (2) Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum.

A firm must generate sufficient cash flows to make debt- service payments in order for it to continue to operate. This minimum cash flow point, often referred to as the point of financial distress, lies left of the centre of the distribution of expected cash flows. Hedging reduces the likelihood of the firm’s cash flows falling to this level. (3) Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm. Regardless of the level of disclosure provided by the firm to the public, management always possesses an advantage in the depth and breadth of knowledge concerning the real risks and returns inherent in any firm’s business. (4) Markets are usually in disequilibrium because of structural and institutional imperfections, as well as unexpected external shocks (such as an oil crisis or war). Management is in a better position than shareholders to recognize disequilibrium conditions and to take advantage of one-time opportunities to enhance firm value through selective hedging.

There are four main types of transactions from which transaction exposure arises: (1) Purchasing or selling on credit goods or services when prices are stated in foreign currencies, (2) Borrowing or lending funds when repayment is to be made in a foreign currency, (3) Being a party to an unperformed foreign exchange forward contract, and (4) Acquiring assets or incurring liabilities denominated in foreign currencies. An important aspect to be notices is that the foreign currency cash balances do not create transaction exposure, even though their home currency value changes immediately with a change in exchange rates. No legal obligation exists to move the cash from one country and currency to another. If such an obligation did exist, it would show on the books as a payable (e.g., dividends declared and payable) or receivable and then be counted as part of transaction exposure. Nevertheless, the foreign exchange value of cash balances does change when exchange rates change. Such a change is reflected in the consolidated statement of cash flows and the consolidated balance sheet (Smith, 1990).

Foreign exchange transaction exposure can be managed by contractual, operating, and financial hedges. The main contractual hedges employ the forward, money, futures, and options markets. Operating and financial hedges employ the use of risk-sharing agreements, leads and lags in payment terms, swaps. The term natural hedge refers to an off-setting operating cash flow, a payable arising from the conduct of business. A financial hedge refers to either an off-setting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap. Care should be taken to distinguish operating hedges from financing hedges. A forward hedge involves a forward (or futures) contract and a source of funds to fulfil the contract. In some situations, funds to fulfil the forward exchange contract are not already available or due to be received later, but must be purchased in the spot market at some future date.

This type of hedge is “open” or “uncovered” and involves considerable risk because the hedge must take a chance on the uncertain future spot rate to fulfil the forward contract. The purchase of such funds at a later date is referred to as covering. A money market hedge also involves a contract and a source of funds to fulfil that contract. In this instance, the contract is a loan agreement. The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency.

Funds to fulfil the contract – to repay the loan – may be generated from business operations, in which case the foreign exchange spot market when the loan matures (uncovered or open money market hedge). Hedging with options allows for participation in any upside potential associated with the position while limiting downside risk. The choice of option strike prices is a very important aspect of utilizing options as option premiums, and payoff patterns will differ accordingly. Ultimately a treasurer must chose among alternative strategies to manage transaction exposure by using two main decision criteria. The two main decision criteria are:

(1) Is treasury a cost centre or a profit centre? And
(2) What is the tolerance for risk?

According our research on 10 Romanian multinationals some trends reviled by the literature could be identified as holding, in line with the general tendency: I. The treasury function of most private firms is usually considered a cost centre. The treasury function is not expected to add profit to the firm’s bottom line. Currency risk managers are expected to err on the conservative side when managing the firm’s money. II. Firms must decide which exposures to hedge:

Many firms do not allow the hedging of quotation exposure or backlog exposure as a matter of policy. Many firms feel that until the transaction exists on the accounting books of the firm, the probability of the exposure actually occurring is considered to be less than 100%. An increasing number of firms, however, are actively hedging not only backlog exposures, but also selectively hedging quotation and anticipated exposures. Anticipated exposures are transactions for which there are – at present – no contracts or agreements between parties. As might be expected, transaction exposure management programs are generally divided along an “option-line”; those that use options and those that do not.

Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges. Many multinational companies have established rather rigid transaction exposure risk management policies that mandate proportional hedging. These contracts generally require the use of forward contract hedges on a percentage of existing transaction exposures. The remaining portion of the exposure is then selectively hedged on the basis of the firm’s risk tolerance, view of exchange rate movements, and confidence level. (Brys, 1998). REFERENCES: Bodnar, Gordon M., “Wharton survey of financial Risk Management by Non-Financial Firms” Financial Management , Vol. 24, No 4, 1998, pp. 70-91


This paper uses a large Australian multinational corporation as a case study examining foreign exchange operating exposure. We firstly review the importance of operating exposure for a business and then examine in detail the company’s exposure and policies to manage the exposure. A sensitivity analysis is also conducted to examine how movements in the value of exchange rates affect the company. We conclude with some suggestions as to how the company could further protect itself from adverse movements.


The effects of exchange rate movements are important to firms engaging in international business. It is usual to differentiate three types of currency exposure. The first is translation exposure, also known as accounting exposure. This refers to the impact exchange rate changes can have on a firm’s value from producing a consolidated set of accounts. That is, when the parent and all subsidiaries account are combined for a group report. The second is transaction exposure that is defined as the potential change in the value of a financial position due to changes in the exchange rate between the inception of a contract and the settlement of the contract. The third is operating exposure that is the extent to which an exchange rate change, in combination with price changes, will alter a company’s future operating cash flow.


This case study considers an Australian corporation’s operating exposure management practices. The primary analysis seeks to explain alternatives available to the company to manage its operating exposure. This will be done in three steps. The first step is to identify the exchange risk faced by the company by analysing its operation. The second step is to identify factors that affect the company’s cash flow with respect to changes in exchange rate and to determine the sensitivity of the company’s cash flow to changes in exchange rate by using sensitivity analysis. The last step is to show how the company could manage its operating exposure. REFERENCES: Guégan D, How Can We Dane the Concept of Long Memory? – An Econometric Survey, No 178, April 2004

CORPORATE RISK MANAGEMENT AND HEDGING PRACTICE BY MEDIUM SIZED COMPANIES IN DENMARK An empirical investigation of the determinants of companies’ foreign exchange risk management


This thesis presents insight into two corporate risk management areas: Using a questionnaire approach, it presents actual empirical evidence about corporate risk management practice and behaviour of industrial, unlisted medium-sized firms in Denmark; and, using regression analysis, investigates the determinants of the usage of derivatives and foreign debt as means to manage foreign exchange rate exposure. The results indicate that every second company is using derivatives and that the use of foreign debt is even more pronounced among larger companies. In their management of foreign exchange exposure, Danish medium-sized companies mainly hedge contractual commitments and anticipated transactions. Their main concerns when using foreign exchange derivatives or foreign debt is the quantification of underlying exposure and the overall transaction costs involved. Prior findings in this area are confirmed as firm size and foreign exchange exposure are significant indicators for derivative usage. The results also suggest that foreign exchange derivatives and foreign debt are seen and used as substitutes when managing foreign exchange rate exposure.


As commonly encountered in the finance literature, most of the academic research on firms’ risk management practice and behaviour has been conducted in the United States (see for example Bodnar et al. 1995, 1996, 1998, Géczy et al. 1997, Nance et al. 1993), and to a lesser extent also in the United Kingdom (Marshall 2000, Mallin et al. 2001). Australia and New Zealand (Nguyen and Faff 2002, Berkman et al. 1997), and the rest of Europe (Bodnar and Gebhardt 1998 on Germany, Hagelin and Alkebäck 1999, Hagelin 2003 for Sweden) are covered only sporadically. Moreover, the focus of the majority of these studies is on large multinational corporations. Research on medium-sized companies is rarely found. General findings of these studies include that firms that hedge part or all of their risk exposures are generally larger, have more valuable growth opportunities in their investment portfolio, are financially more constraint, and are exposed to a higher degree to foreign exchange exposure than companies that do not hedge using derivatives or foreign debt (see for example Géczy 1997, Nance 1993).

Bodnar et al. (1995) also indicate that derivatives are not commonly used for speculation but mostly used to hedge committed and anticipated transactions. Other means of an integrated risk management approach such as operational means or capital structure adjustments are rarely accounted for in these studies. One must also bear in mind the differences concerning the extent of research conducted: While some researchers present findings consisting of descriptive evidence about the dimension of corporate risk management and hedging practice, others investigate the theoretical determinants of corporate risk management and the usage of derivatives and foreign debt Still, besides a general common focus of research on the U.S., several authors have investigated corporate risk management policies and derivative usage in countries across Europe that exhibit similar characteristics as Denmark, such as being a small and open economy with a high rate of imports and exports, and having hence higher exposure to financial price risks, such as foreign exchange rates.

Moreover, small countries’ national financial markets exhibit generally a lower sophistication and companies are therefore more pronounced to also act on financial markets abroad, which will impact a company’s behaviour in relation to derivatives and foreign debt usage. Besides those two areas (degree of openness of the economy and differences in the financial environments), Bodnar, de Jong, and Macrae (2003) take in their comparison of derivative usage in the United States and the Netherlands into account also shareholder vs. stakeholder orientation, and differences in accounting regulation and disclosure. Therefore, it should be considered that results of studies conducted in different countries are always influenced by the institutional settings of the country (Bodnar, de Jong, and Macrae 2003, p.272f). Previous research can also be found from the same geographic region as Denmark, namely in Northern and Western Europe.

Consequently, related empirical results are presented from research conducted in Sweden, Finland, Belgium, and the Netherlands. However, it must be kept in mind that comparisons between different studies must not only be not meaningful because of differences in national institutional settings. Besides variations in questions asked, survey results are based on responses from different years, and companies vary across different sizes, industries, and other company characteristics. Recent empirical findings published by Hagelin (2003) and Pramborg (2005) covering non-financial Swedish companies, and Aabo (2006) covering foreign debt usage in Denmark is used to compare the survey findings of this thesis throughout the result.


The questionnaire constructed for this research thesis is designed for industrial, medium-sized companies in Denmark and asks questions about company characteristics and corporate risk management practices. It is constructed based on the inspiration of other research studies such as Bodnar et al. (1995, 1998), but adjusted and matched to the purpose of this particular research focus, namely unlisted, medium-sized firms in Denmark. The survey is divided into three parts and includes the option to exit the survey after the first seven questions. The respondent companies can decide themselves to answer the whole survey or only the first part of it. The first part deals in seven questions with basic company characteristics and asks if the company has used derivatives within the last year. The respondent company is then asked to continue with the following nine questions if it is using derivatives or foreign debt to manage foreign exchange rate exposures at least to some extent, or to skip part two and three and to exit the survey. While part two asks further questions about the use of derivatives and foreign debt for foreign exchange risk management purposes, the last part deals in two questions with detailed foreign exchange exposures and the means of an integrated risk management approach to handle those different foreign exchange exposures.

The option to exit the survey after the first part is made available to attract companies to participate in the survey. The invitation email sent to the companies explicitly stated that also companies that are not facing significant foreign exchange exposure or are not using derivatives or foreign debt are asked to answer at least the first seven questions of the survey. Giving those companies the possibility to answer the first seven questions and then to exit the survey, it is assumed that a lot more companies were attracted to participate than would have been if the possibility to exit the survey after the first part had not been given. As will be explained in detail later on, of the total 164 respondent companies, 119 decided to exit the survey after the first nine questions, and 45 firms (27.4%) decided to continue with the whole survey.

As opposed to conducting the survey as a paper-based questionnaire, it was chosen that an online, web-based survey will be carried out. Advantages for conducting the survey online include lower overall costs, more comfortable and quicker processing for responding companies, and an easier overall management of the survey organisation. As online survey tool the free-of-charge Stud Survey-tool provided by the Aarhus School of Business’ IT-Department is used to design and carry out the questionnaire.

The functionality of the Stud Survey-tool comprises a complex form builder with which questions and answers can be specified, designed, and adjusted to varying requirements, a survey test function, a mailing function, and functionality to analyse data online and to export it into different file formats. Especially the mailing function of the Stud Survey-tool was important as it allowed tracking back the responses to the company that gave a specific response by mailing a unique questionnaire code to every firm (a function called email code protection). R


Beaver, W. H.; Parker, G. (1998): Risk Management: Problems and Solutions, 3rd edition, Stanford University, Financial Services Research Initiative, McGraw-Hill

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