Corporate Foreign Exchange Risk Management

Chapter 2Commercial Exposure to FX

The previous chapter established a basic approach to FXRM: that is, managing FX exposures so as to keep the risk of breaching critical threshold levels of performance acceptably low. Regardless of which performance metric is ultimately chosen, a keen understanding of the firm's exposure to risk is a prerequisite for being successful at this task.

A good place to start in the quest for a solid understanding of how performance relates to exchange rates is the firm's commercial exposure. In our usage of the term, commercial exposure is largely synonymous with the exposure on cash flow generated through its various business activities, or its operating cash flow. At this point we leave out financial and temporary effects such as those generated by asset sales or other restructurings. Our interest lies in the core operating performance of the firm, which is to say its revenue and the costs it incurs in the process of generating that revenue. Most of the other tasks in FXRM become much more difficult, or even meaningless, if the firm's commercial exposure is poorly understood. In many ways, a firm constructs its portfolio of derivatives and debt instruments so that the exposures on these items balance out those resulting from the commercial activities. Therefore, there is hardly any basis for making FXRM decisions if this crucial piece of information is lacking.

This chapter describes concepts and methods that can be used in quantifying a firm's ...