Risk

Foreign Exchange Exposure

Run a real hedging program: split the exposure into three kinds, hedge only the kind that moves cash, and know what the bank will ask you to post before the market asks for it.

  • Advanced
  • 7 min total
  • 12 chapters

What decision this helps you make: Which currency exposures to hedge, with which instrument, for how far out, and what share of a forecast a company can responsibly cover.

What this topic is

Foreign exchange exposure is the sensitivity of a company's cash, earnings, and competitive position to exchange-rate movement. It comes in three separable kinds: transaction (deals already booked), translation (an accounting restatement of foreign subsidiaries), and economic (the slower repricing of your competitiveness). Only one of them is naturally fixed with a bank contract.

Why it matters

A hedging program is one of the few risk activities that can lose real money while working exactly as designed: a winning forward is a losing derivative, and the bank calls for collateral today while the offsetting operating benefit arrives in ninety days. Companies that understood the split, sized the ratio, and pre-funded the collateral rode currency cycles; companies that hedged the accounting line paid cash to fix an equity entry.

Who should learn it

Finance leads and owners at companies with contracted cash flows in another currency: exporters, importers with foreign-currency purchase orders, anyone with a foreign subsidiary or foreign-currency debt.

What you will understand

  • Split exposure into transaction, translation, and economic, and treat each differently
  • Price a forward yourself, and see why forward points are not a forecast
  • Choose between forwards, options, and collars on their real tradeoffs
  • Write a hedge policy: ratios by tenor, tenor limits, and a no-speculation rule
  • Anticipate the collateral call a successful hedge produces

Prerequisites

Common misconception

"A good hedge makes money." A hedge that makes money is a hedge whose underlying business exposure just lost money. That is the entire point, and the two are supposed to cancel. Treating hedge profit and loss as a scorecard is how treasury desks quietly become trading desks: they start lifting hedges when the rate "looks good," which converts a risk program into a position. The correct scorecard is variance of the combined result, not the sign on the derivative.