Page 104 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 6: Economic Fundamentals and Foreign Exchange Risk Exposure

6.5 Summary Notes

The foreign exchange business is, by its nature risky because it deals primarily in risk –
measuring it, pricing it, accepting it when appropriate and managing it. The success of a
bank or other institution trading in the foreign exchange market depends critically on
how well it assesses, prices, and manage risk, and on its ability to limit losses from
particular transactions and to keep its overall exposure controlled.
Managing foreign exchange risk is a fundamental component in the safe and sound
management of companies that have exposures in foreign currencies. It involves prudently
managing foreign currency positions in order to control, within set parameters, the impact
of changes in exchange rates on the financial position of the company. The frequency and
direction of rate changes, the extent of the foreign currency exposure and the ability of
counterparties to honour their obligations to the company are significant factors in foreign
exchange risk management.

There are mainly three type of foreign exchange exposure - translation exposure, transaction
exposure and economic exposure. Transaction exposure refers to the degree to which a
firm’s foreign currency denominated financial statements are affected by exchange rate
changes. It is also known as accounting exposure. Transaction exposure refers to the extent
to which the future value of a firm’s domestic cash flow is affected by exchange rate
fluctuations. Economic exposure, which is more a managerial concept, refers to the degree
to which a firm’s present value of future cash flows can be influenced by exchange rate
fluctuations.
Forwards, futures, option and swaps are important tools to manage foreign exchange risk.

Forwards and futures are agreement in which one business agrees to buy from or sell to
another business a determined quantity of an underlying asset (real or financial), at a
specified future date and at a set price. Two parties mutually agree on a forward contract,
according to their needs. Futures are standardised contracts traded on an exchange by
brokers.
Options grant the holder the privilege or right to buy or sell an underlying asset, at a
stated price, during a specified period or at a set date.

With swaps, two parties (one of which is usually a financial institution) agree to exchange
their loan or currency payments during a specified period.

6.6 Keywords

Capacity Utilization: Capacity utilization consists of total industrial output divided by total
production capability. The term refers to the maximum level of output a plant can generate
under normal business conditions.
Consumer Price Index: Consumer price index reflects the average change in retail prices for a
fixed market basket of goods and services.
Durable Goods: Durable goods orders consist of products with a life span of more than three
years.
Gross Domestic Product (GDP): The Gross Domestic Product (GDP) refers to the sum of all
goods and services produced in the country, either by domestic or foreign companies.
Gross Domestic Product Implicit Deflator: Gross domestic product implicit deflator is calculated
by dividing the current dollar GDP figure by the constant dollar GDP figure.

LOVELY PROFESSIONAL UNIVERSITY 99