Foreign exchange rate changes represent an important source of risk for non-financial corporations. Spectacular losses or even bankruptcies over the last decade and longer have drastically demonstrated the consequences of unprofessional management of these risks.1 With the emergence of large currency blocs with their own, internally focused macro-economic policies, together with the parallel rise in the international involvement of firms (usually referred to as “globalization”), and the opening of markets through more liberal trade policies and the technology-driven reduction in transportation costs, the number of firms impacted directly or indirectly by exchange rate changes has dramatically grown.
Corporate foreign exchange risks began to attract widespread attention during the 1970s when the Bretton Woods system of fixed exchange rates unraveled. The subsequent rise in volatility of exchange rates and interest rates fostered a burst of financial innovation, exemplified by the proliferation of derivative instruments and their increasing use by corporations in all industry sectors (see e.g., Bartram et al., 2004 and Bodnar et al., 2008). Derivatives can be quite efficient hedging instruments for corporate risk management. Nevertheless, they can be quite complex as well, with strong leverage effects. Consequently, the use of these instruments carries with it high risks - both for the unsophisticated user, as well as for executives tempted by gambling with their shareholders' money. In contrast, when properly used for hedging, derivatives or various other financial transactions can reduce those risks of non-financial firms for which they are not rewarded in the market. Since the term “hedging” is widely misused in practice, a clear conceptual foundation is key to management action consistent with the objective of firm value maximization.
Hedging requires first and foremost an understanding of the underlying risk position: it means creating a position to offset an exposure. A hedge can be implemented either in the cash market or with derivatives. In contrast, “speculation” means taking actions in view of an explicit or implicit forecast that deviates from that of the market (as revealed, for example, by forward rates or interest differentials in functioning markets). In other words, a good test of whether an action involves hedging or speculation is the presence or absence of a causal relationship to the underlying exposure of the firm. This consideration focuses the agenda firmly on the definition and estimation of the exposure of firm value due to unexpected exchange rate changes. Here is where problems begin: the literature offers three definitions of exposure, namely accounting, transaction and economic (or “cashflow”), but only the latter is consistent with financial theory.
Foreign exchange rate risk in general is related to unexpected changes in foreign exchange rates. It can be quantified with the statistical measure of variance or standard deviation. More specifically, foreign exchange rate risk exists because international parity conditions such as Purchasing Power Parity and the International Fisher Effect hold at best in the long run. Consequently, there is no immediate adjustment among exchange rates, interest rates and prices for goods and ...