The Costs of Altering Exposure to Exchange Risk

Abstract

Risk neutralisation involves structuring the currency mix of the firm’s assets and liabilities so that changes in exchange rates will have minimal impacts on its income, net worth, and market value.¹ The firm with a long position in the pengo can reduce its exposure by acquiring additional pengo liabilities; the firm might borrow pengos and use the loan proceeds to buy dollars or it might sell the pengo forward.² As a first step, the firm should estimate the impact of anticipated changes in exchange rates on its income and market value with the current mix of assets and liabilities denominated in various currencies, and then with alternative mixes of assets and liabilities denominated in these currencies. ³ This chapter describes the techniques that can be used to alter the firm’s exposure to exchange risk and the costs or returns associated with such changes.⁴