Question

What are the opportunities and benefits of Exchange Rate Exposure Management?

Answer 1

Financial exposures and risks faced by the firms influence the value in many direct and indirect ways. Typically, these exposures are created as a result of unexpected changes in exchange rates, interest rates, and commodity prices. The term risk and exposure is often interchangeably used, but there is a subtle difference between the two. Risk refers to the probability of a loss, whereas exposure is the possibility of a loss. Risk arises from the exposure or exposure precedes risk. When a firm has financial market exposure, there is a possibility of loss nevertheless an opportunity for gain or profit [1]. Therefore it is not possible to eliminate the exposure or risk as there is a linear relationship between risk and returns. But the firms can manage these risks by deploying proper risk management techniques in other words firms can hedge these exposures.

The fact that a significant number of corporations are committing resources to risk management (financial hedging) activities indicates the role for risk management in increasing the firm value [2]. Besides increasing the value of the firm, it also provides greater consistency to the firms earnings and reduces the cost of capital [3,4].

The present research intends to study the level exchange rate exposure of the firms in India. Exchange rate exposure is the uncertainty created by the unintuitive movement in the exchange rates between the currencies. Hekman [5] defined exchange rate exposure (referred as FX exposure hereafter) as “the sensitivity of its economic value, or stock price, to exchange rate changes”. The foreign exchange rate exposure is created by firm’s transactions such as, import, export, borrowing, lending, subsidiaries in foreign country, royalty income/expense and so on. This exposure so created brings in the probability of loss, which is called as foreign exchange rate risk. This is a unique risk attached with the international trade, i.e. when firms operate in more than one country.

The international trade has significantly grown following the Second World War. Large number of corporations started exploring the opportunities in the foreign countries as a part of their expansion strategy. Indeed, the global trade was vital in success of many businesses. The political environment post the Second World War was stable and conducive enough to do so and more importantly creation of World Trade Organization, World Bank etc. made the international business much easier. In the Indian context, after the liberalization of Indian economy in the year 1991 opened windows for global business in India, many global multi-national corporations (MNCs) entered Indian markets; similarly, many Indian companies cashed this opportunity to enter foreign countries. Because of this the firms were exposed to a FX risk which was not there when they were operating in the domestic country. However the magnitude of FX risk was very less, with the operation of Bretton Woods Agreement signed by most of the economically powerful countries in the year 1944. With the fall of Bretton Woods System and introduction of flexible exchange rate regime in the year 1972, the movement of the exchange rates became very volatile as the exchange rate between the currencies of two countries was determined by market forces. This development in the global economy, lead to the increased importance to FX risk management. The past researches conducted on FX risk management and firm value indicates the managing the FX risks will increase the value of the firm [6-8]. Therefore, no firms involved in global trade could afford to demine the importance of managing FX exposures.

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