Corporate Finance: Analyzing Exchange Rate Risk and Hedging Strategies

This report delves into the critical aspects of corporate finance, specifically focusing on exchange rate risk and hedging strategies. The report begins by defining and differentiating between transaction risk, translation risk, and economic risk, providing a comprehensive understanding of the various types of currency-related exposures. It then explores practical hedging strategies, including the use of forward contracts, money markets, and options, to mitigate the impact of exchange rate fluctuations on a company's financial performance. Furthermore, the report highlights the importance of understanding the impact of exchange rate changes on revenues, operating expenses, and overall profitability. The analysis is supported by academic references, providing a robust framework for understanding and managing exchange rate risk in a corporate environment. This assignment provides valuable insights into the practical application of financial management principles in a globalized business context.

Running head: CORPORATE FINANCE
Corporate finance
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Table of Contents
Answer 1....................................................................................................................................2
Answer 2....................................................................................................................................2
Reference....................................................................................................................................4

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Answer 1
Transaction risk – it is basically the risk associated with cash flows and it deals with effect
of the moves in exchange rates with regard to the exposures of transactional account
associated with payables that is import contracts, receivables that is export contracts or
dividend repatriation. Any changes in the exchange rate of currency denomination will lead
to direct transaction risk for exchange rate of the firm.
Translation risk – this risk is basically the exchange rate risk associated with balance sheet
and is related to the movement of exchange rate with the valuation of foreign subsidiary. The
translation risk associated with foreign subsidiary is generally measured through the net
assets exposures with the movements of potential rate of exchange.
Economic risk – basically it reflects the risk associated with the present value of the firm’s
future operating cash flows generated from movements in exchange rate. The economic risk
is concerned about the exchange rate changes impact on the revenues including exports and
domestic sales and the operating expenses including the imports and cost of the domestic
inputs (Bodnar et al. 2013).
Answer 2
Transaction exposure may be hedged through operational techniques like choice of
the invoice currency, lag/lead strategy and through exposure netting. It can also be minimized
through following -
 Forward contracts – if the company is required to pay specific amount of the foreign
currency in future, it may enter into a contract that will fix price of foreign currency at
future date.

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 Money market – it is equal to the current spot price and is multiplied by ratio of
riskless return of the currency.
 Options – it involves upfront fees and the owner is not obliged to trade at specific
price (Chang, Hsin and Shiah-Hou 2013).

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Reference
Bodnar, G.M., Consolandi, C., Gabbi, G. and Jaiswal‐Dale, A., 2013. Risk Management for
Italian Non‐Financial Firms: Currency and Interest Rate Exposure. European Financial
Management, 19(5), pp.887-910.
Chang, F.Y., Hsin, C.W. and Shiah-Hou, S.R., 2013. A re-examination of exposure to
exchange rate risk: The impact of earnings management and currency derivative
usage. Journal of Banking & Finance, 37(8), pp.3243-3257.