Opposite relationships hold for net asset positions, which are denominated in an FC.
As a result of the cash flow impact of transaction exposures and the requirements of Financial Accounting Standards Board Statement no. 52, Foreign Currency Translation, to include foreign exchange transaction gains and losses in the determination of net income, most companies are hedging these exposures. In fact, a 1986 FASB research report, Foreign Exchange Risk Management under Statement 52, revealed that 84% of 162 company treasurers engaged in foreign trade regularly or selectively hedge foreign transaction exposures.
The research of the problem of the foreign currency risk is important because the globalization of the world economy and the devaluation of the U.S. dollar have allowed more American companies to enter the export/import markets. Additionally, many managers who previously avoided these markets are finding that international transactions can make their companies more competitive in marketing products and procuring parts and/materials. As new companies are exposed to foreign exchange risk, managers will necessarily be concerned with the development of an effective hedging program. While the task of managing financial risks generally falls to the CFO or treasurer, it is often others in the accounting department who are asked to evaluate the bottom line impact of these risks. The proposed research paper will introduce several of the most widely practiced hedging policies and strategies that will add a new knowledge to the field of foreign exchange currency trading risk and management through the research within a number of multinational companies that face the risk.
Besides providing a real organizational case, the research focuses on the modern risk management strategies that include applying foreign exchange derivatives. Employing the sample of firms for the research, current paper focuses on foreign currency and interest rate derivatives.
Review of the literature
Foreign exchange exposure is defined as the effect of unexpected changes in the real exchange rate on firms (see Adler and Dumas, 1980; and Cornell and Shapiro, 1983). There are two types of economic exposure: Transaction exposure is the effect of unexpected changes in the nominal exchange rate on cash flows associated with monetary assets and liabilities (i.e., contractually fixed cash flows).
Transaction exposure is usually a short-term exposure that can be easily hedged using currency derivatives. Operating exposure is the effect of unexpected changes in the exchange rate on cash flows associated with a firm's non-monetary (real) assets and liabilities.
Operating exposure is typically a long-term exposure that can usually be best managed through the implementation of operational hedges (see Flood and Lessard, 1986). For example, consider a firm with foreign currency cash flows that are known with certainty. The sole source of uncertainty for the firm is the exchange rate. This (transaction) exposure can easily be hedged using forward contracts. However, the use of derivatives cannot eliminate risk if the quantity of the foreign cash flows is also uncertain and not perfectly correlated with the exchange rate. These firms can rely on operating adjustments such as shifting their