Measuring and Managing Foreign Exchange Risk Dissertation

Measuring and Managing Foreign Exchange Risk - Dissertation Example Although a firm may hedge its foreign exchange contracts, limiting its transaction exposure, economic exposure is difficult to estimate and further, hedge. Economic exposure arises because future profits from operating as importer or exporter depend on exchange rates, and due to its nature, this type of exposure is difficult to mute. (Faff & Iorio 2001, Mullem & Verschoor). (Mullem & Verschoor, 2005). However, there is greater complexity between the relationship between exchange rate fluctuations and competitiveness and this leads to difficulty in correctly estimating economic exposure and hence hedging it efficiently (Mullem & Verschoor, 2005). Firms that do business abroad must be ready to account for changes in exchange rates that lead to variability in their cash flows. (Solt & Lee, 2001). Transaction exposure reflects the risk that exchange rates change between the time a transaction is recorded and the time actual receipt of cash or payment of cash is made. (Solt & Lee, 2001). Due to its short-term nature futures and forwards can be used to hedge transaction exposure and thereby eliminate its influence on the value of a firm. (Solt & Lee, 2001). Economic exposure, on the other hand, is the long-term effect of exchange rate changes on the future cash flows and thereby on stock returns. (Solt & Lee, 2001).