Corporate Foreign Exchange Risk Management

Chapter 5FX Derivatives Explained

Derivatives are financial instruments whose value derives from an underlying reference variable or price. Today, thanks to financial engineering, the underlying can be almost anything: movie revenues, the weather, or freight rates are just some examples. The bulk of derivative contracts, though, are written on prices or rates observable in the financial markets, such as stock prices, interest rates, and – of course – foreign exchange rates. The price of an FX derivative therefore depends on the value of a specific exchange rate. As the value of the exchange rate fluctuates, the price of the derivative will change according to the specific pricing formula that links the two.

Surveys of corporations show that a significant majority of firms with exposure to exchange rates use FX derivatives. They are used either to manage risk, or to take speculative views on markets. Many strongly associate FXRM with derivatives, almost to the point where the two become synonymous. We disagree with this view. While derivatives are often an integral part of FXRM, they are only one way of managing FX risk. Equally important to consider are natural hedges¹ and the currency composition of corporate assets and liabilities, not least debt. Furthermore, derivatives are usually limited in that they are only able to influence the risk profile in the short to medium term, whereas firms often have projects that span decades.

The main advantage of derivatives as a tool ...