Corporate Foreign Exchange Risk Management

Chapter 1Why Manage Foreign Exchange Risk?

One of the more puzzling questions facing corporate management is the risk management decision. This is about deciding whether to use a company's resources to actively try to reduce risk, here understood as variability in corporate performance. Our focus in this chapter is therefore to understand when it makes sense for a firm to reduce variability in its performance through managing its FX exposures. Why would a firm be better off managing risk than just accepting its exposures as part of doing business?

To fix our ideas, we can take hedging as a proxy for corporate risk management. Hedging is the use of financial derivatives to alter a firm's exposure to a specific market risk. Many other forms of risk management are possible, like buying insurance, operational risk mitigation, relying on equity rather than debt financing, and keeping a buffer of cash to deal with adverse outcomes. We will in fact emphasize that hedging, while highly flexible, is for the most part only able to address relatively near‐term exposures (more on this in Chapter 9). By changing the currency exposure at an operational level (i.e. actively trying to net out cash inflows and cash outflows), or by borrowing long term in foreign currency, the firm is likely to achieve more durable reductions in FX risk.

Focusing on hedging for now, however, allows us to keep the terminology brief and tap into a rich literature that has developed on why firms should hedge their ...