How Might Exchange-Rate Risk Be Managed
2) How might exchange-rate risk be managed? Financial management of the international firms is more concern on manage exchange-rate risk because this exposure is a measure of the potential for a firm’s profitability. Generally, it divided into transaction exposure and translation exposure. The transaction exposure means changes in the value of outstanding financial obligation incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. Thus, it deals with changes in cash flows that result from existing contractual obligations. (Moffett, Stonehill, & Eiteman, 2006) Transaction exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations. This exposure is face by companies involved in international trade such as purchasing or selling goods or services when prices are stated in foreign currencies or borrowing or lending funds when repayment is to be made in a foreign currency. On the other hand, translation exposures occur when the financial statement of foreign subsidiaries which are stated in foreign currency and restated it to parent’s reporting currency in order to prepare a consolidated financial statement. It is important to parent’s company to increase or decrease their net worth and reported net income because the exchange rates are keeping changing.
In the Baker’s case, it is more related to the transaction exposure rather than translation exposure. The only way to manage exchange-rate risk in financial market is through hedging, which involves taking a financial position to reduce one’s exposure or sensitivity to a risk. Hedging is perfect when all exposure to the risk is eliminated through the financial position. Generally, the international firms are using derivative market to hedge with foreign exchange-rate risk such as forward, future, option and swap contract. The use of derivatives is not new as risk management tools, so named derivative is because their values are derived from an underlying asset such as a commodity or a currency. Back into case, the forward and money-market hedges was discussed in detail below. At this point, it is sufficient to acknowledge that these financial contracts are able to mitigate the risk. Therefore, we attempt to go others possibilities that can manage foreign exchange-rate risk in Baker’s transaction. Exclude the forward and money-market hedges, Baker can also use future contract and foreign currency option to hedge with foreign exchange-rate risk. Given that futures contracts is similar to forward contract but it is traded in exchange with standardize contract. However, future contracts are available in only certain sizes, maturities and currencies, it is generally not possible to get an exactly offsetting position to totally eliminate the exposure. On the other hand, Baker can also consider in using currency foreign options hedges with currency exposure. An option contract gives its holder the right but not the obligation to trade the domestic currency for foreign currency (or vice versa) in a fixed number of currencies at a given price at some future date. The specified price is called the exercise price. However, the future and option contracts are beyond the scope of this case and lack of information for Baker calculation, but it should be acknowledged to mitigate in foreign exchange-rate risk.