Chapter 19 Summary

LO 19.1 Impact of Exchange Rate Fluctuations

• Exchange rate fluctuations not only impact the decision making of big/small trade organizations but also impact the decisions taken by governments and banks.
• For firms that depend on export sales, or firms that rely on imported inputs to production, or even purely domestic firms that compete with firms tied into international trade, sharp movements in exchange rates can lead to dramatic changes in profits and losses.
• A central bank may desire to keep exchange rates from moving too much as part of providing a stable business climate, where firms can focus on productivity and innovation, not on reacting to exchange rate fluctuations.
• Any fluctuations in currencies adversely impact bank operations and can make a country’s banking system bankrupt.

LO 19.2 Transaction, Translation, and Economic Exposure

• Transaction risk is the risk that the value of a business’s expected receipts or expenses will change as a result of a change in currency exchange rates. It is short-term to medium-term in nature.
• Translation risk is the impact currency fluctuations have on company’s consolidated statements when it has foreign subsidiaries. Translation risk is an accounting risk and is medium term to long-term in nature.
• Economic Risk arises due to the impact currency fluctuations have on company’s cash flows. Economic exposure is long-term and has adverse effects on company’s market value.

LO 19.3 Different Ways of Managing Currency Risk

• Hedging allows companies to mitigate currency risk by entering into future and forward contracts.
  • A futures contract is an agreement to trade an asset on some future date at a price locked in today.
  • A forward contract is simply a contractual agreement between two parties to exchange a specified amount of currencies at a future date.
• A natural hedge occurs when a business can offset its risk simply through its own operations.
• A financial option gives the owner the right, but not the obligation, to purchase or sell an asset for a specified price at some future date.
  • Options are divided into two main categories: call options and put options.
  • A call option gives the owner of the option the right, but not the obligation, to buy the underlying asset.
  • A put option gives the owner the right, but not the obligation, to sell the underlying asset.
• A swap is a financial instrument that allows two parties to exchange a series of payments in one currency for a series of payments in another currency.

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