Foreign Exchange Rate Risk

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 the foreign country of investment costs to the home office in the United States.

Strategies for Dealing with Foreign Exchange Risk

Hedging and futures trading are two strategies to manage foreign exchange risk (Madura, 2002). If a hedger is sufficiently skilled, risk can be fully hedged ยท a situation where the transaction will have no impact on the owner’s assets (Brooks, Henry, & Persand, 2002). The typical intent of the hedger, however, usually is not t…

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