MANAGING TRANSACTION EXPOSURE AND ECONOMIC EXPOSURE

Abstract

Foreign exchange risk is the risk of loss due to changes in the international exchange value of national currencies. So long as we do not have a single world currency, some degree of exchange risk will exist, no matter what the system. Fluctuations in the value of currency had been quite frequently pronounced even under the fixed exchange rate system. A study by DeVries, for example, shows that during the 20-year period from 1948 to 1968, 96 countries devalued their currencies by more than 40 percent, and 24 countries devalued their currencies by more than 75 percent. This problem has become more complicated in the last five decades because most countries have permitted their currencies to float since 1973. Daily currency fluctuations and frequent currency crises have become a way of life since then. Daily currency fluctuations and the increasing integration of the world economy are two major reasons why multinational companies (MNCs) consider exchange rate risk as the most important one among many risks.This chapter has three major sections. Section 7.1 describes the basic nature of foreign exchange exposure. Section 7.2 explains how transaction exposure can be measured and hedged. Section 7.3 explains how economic exposure can be measured and hedged.