Reading 38: Risk Management Applications of Forward and Fu

The three types of exchange-rate risk are transaction exposure, economic exposure, and translation exposure. Futures are most often used to hedge transaction exposure, which is the risk that exchange rates will change the real value (in the domestic currency) of the contracted price.

Economic exposure is the loss of sales that a domestic exporter might experience if the domestic currency appreciates relative to a foreign currency. That is, if the euro/dollar exchange rate increases, a U.S. exporter to Europe would see a fall in revenue as the European buyers purchase fewer U.S. exports that have effectively increased in price from the dollar appreciation.

Translation exposure refers to the fact that multinational corporations might see a decline in the value of their assets that are denominated in foreign currencies when those foreign currencies depreciate. When the consolidated balance sheet is composed, changing exchange rates will introduce variation in account values from year to year.
  

In hedging foreign exchange risk, anticipating a receipt (payment) of a currency is like being long (short) the currency. To hedge the associated risk, a manager should take the opposite position in the forward contract.

On the day the order comes in, the firm effectively has a long position in pounds; therefore, it should take a short position in a forward contract. This contract would obligate the firm to deliver the pounds that it will receive for dollars. The contract would be to exchange ₤8 million for:

$10,800,000 = (₤8,000,000)*$1.35/₤.

$10,800,000 = (₤8,000,000)*$1.35/₤.

Expecting to make a payment is like being short the currency. The firm would want to take a long forward position. If the currency appreciates and there is no hedge, the firm would pay more. With the hedge, the overall cost in domestic currency is locked in (cost increases will be offset by gains on the forward contract). Of course, the forward contract will result in a loss if the foreign currency actually depreciates, but this will be offset by a decrease in the cost of the underlying transaction.