Corporate Foreign Exchange Risk Management

Chapter 7Centralizing Exposure Management

Derivatives, on paper, seem to be an almost ideal tool for managing a firm's risk–return profile. In the previous chapter we brought attention to one of the real‐world factors that limit their popularity in practice, namely the fact that they are fair value accounted when business transactions are not. Here, we address another factor that complicates the existence of derivatives in firms. There are, it turns out, many units within a corporate group with their own view on how FX risk should be managed.

The background for this chapter is the seemingly legitimate request of business units to get access to FX derivatives so that they can manage their risk. After all, they are responsible for their own performance and evaluated on their ability to improve it. Often these performance measures are heavily exposed to exchange rate risk. Is it not reasonable, then, that they get access to financial derivatives to manage that risk and protect their performance? FX derivative usage thus comes attached with a management control issue: shall business units be allowed to use FX derivatives, and if so, what rules should guide this activity?

These questions are related to the broader question of who should be responsible for FXRM (of which derivative usage is part). Studies have shown that the managerial factor in risk management is a big one. Contrary to what is assumed in academic theories targeting value maximization, the incentives and preferences ...