Managing Interest and Exchange Rate Risks

Abstract

Company directors have a legal and moral responsibility to preserve the corporate entity. They must not take unnecessary risks leading to financial distress. Excessive borrowing and foreign exchange exposure entail such risk. The most obvious risk is inability to make loan payments when due. In this chapter, however, we shall be concerned with managing the narrower risks associated with changing rates of interest and with changing foreign exchange rates. Companies can hedge risks using various options, forwards, futures, and swap transactions. Hedging is about matching assets and liabilities in a manner that makes the matched combination immune to a source of risk. If a company has cash flows, assets, and liabilities denominated in foreign currencies, exposure to unexpected changes in exchange rates can constitute significant risk for the company. Therefore, the Board cannot leave it to shareholders to hedge the company’s foreign exchange risk exposure within the context of their own portfolios. Shareholders cannot protect the corporate entity or its creditworthiness in this way. Furthermore, a company cannot keep its shareholders sufficiently informed about the company’s current risk exposures for them to hedge their own portfolios effectively. Consequently, it falls to the Corporate Treasurer to hedge at least those risks that plausibly could lead to financial distress.