Foreign Exchange Rate Risk

Foreign exchange rate risk involves the potential for exchange rate changes to harm the financial position of a firm involved in global operations. Transaction exposure concerns the extent to which a firm's transactions are affected by currency fluctuations. Translation exposure concerns the impact that exchange rates have on a firm's balance sheet. Economic exposure concerns the effects of currency exchange rate changes on future prices, sales, and costs (Eun & Resnick, 2000).

For the American manufacturer establishing a production and marketing operation in a foreign country to serve foreign markets, the issues of transaction, translation, and economic exposure will involve (a) the currency exchange rate between the United States dollar ($) and the currency in the host country for the operation and (b) the currency of the host country for the operation and the currencies of the countries whose markets are served. For the American manufacturer shipping from the United States to each foreign market separately, the currency exchange rates between the dollar and the currencies of each of the foreign countries are of concern.

Further, when an American manufacturer establishes an operation in a foreign country, translation exposure will be a concern for the company in relation to the repatriation of profits from the subsidiary in the foreign country to the home office in the United States. Further, translation exposure will apply to the repayment by the subsidiary in th

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or determining the hedge ratio in this model is the face value of the two securities (Association for Investment Management and Research, 2002). Market Value Naive Model: This model requires $1 market value in cash position for each $1 market value in futures position. A naive hedging technique suggests that a futures position should have an equal magnitude and an opposite sign compared to the spot position. The hedge ratio is that ratio where the price changes of both the spot security and the futures security are equal in magnitude and opposite in sign. Calculation of the hedge ratio reflects the relative change in values of the spot security and the futures security anticipated over the life of the hedge. The basis for determining the hedge ratio in this model is the market value of the two securities (Association for Investment Management and Research, 2002). Price Sensitivity (Duration) Model: Dollar duration is not the only measure of price sensitivity used. The traditional, and more intuitive, measure of duration is the Macaulay Duration. The measurement of price sensitivity is the weighted-average term to maturity of the cash flows from a security. The weights are the present value of the cash flow divided by the

Category: Economics - F