Hedging Exposure to Foreign Exchange Risk: The Basic Concepts

Abstract

Foreign exchange risk arises because of uncertainty about the exchange rate prevailing in the future (after a decision involving exchange rate expectations has been taken, such that the outcome depends on the materialisation or otherwise of the expectations). It refers to the variability of the base currency value of assets, liabilities and cash flows (contractual or otherwise) resulting from the variability of the exchange rate. Therefore foreign exchange risk arises when a firm indulges in international operations involving currencies other than the base currency, including importing, exporting, investing and financing. As a result, the firm will be exposed to assets, liabilities and cash flows denominated in currencies other than the base currency. We have to remember that foreign exchange risk is associated with unanticipated changes in exchange rates, since anticipated changes are discounted and reflected in the value of the firm.