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1 - Shareholders are more capable of diversifying currency risk than is the management of the firm. If stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage the risk in a way that satisfies their individual preferences and risk tolerance.

2 - Currency risk management does not increase the expected cash flows of the firm. It does, however, consume firm resources, and so reduces cash flow. The impact on value is a combination of the reduction of cash flow (which lowers value) and the reduction in variance (which increases value).

3 - Management often conducts hedging activities that benefit management at the expense of the shareholders. The field of finance called agency theory frequently argues that management is generally more risk-averse than are shareholders.

4 - Managers cannot outguess the market. If and when markets are in equilibrium with respect to parity conditions, the expected net present value of hedging should be zero.

5 - Management’s motivation to reduce variability is sometimes driven by accounting reasons. Management may believe that it will be criticized more severely for incurring foreign exchange losses than for incurring similar or even higher cash costs in avoiding the foreign exchange loss. Foreign exchange losses appear in the income statement as a highly visible separate line item or as a footnote, but the higher costs of protection are buried in operating or interest expenses.

6 - Efficient market theorists believe that investors can see through the “accounting veil,” and therefore have already factored the foreign exchange effect into a firm’s market valuation. Hedging would only add cost.

1 - Reduction in risk of future cash flows improves the planning capability of the firm. If the firm can more accurately predict future cash flows, it may be able to undertake specific investments or activities that it might otherwise not consider.

2 - Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a level sufficient to make debt-service payments, which are necessary in order for it to continue to operate. This minimum cash flow point, often referred to as the point of financial distress, lies left of the center of the distribution of expected cash flows. Hedging reduces the likelihood of the firm’s cash flows falling to this level.

3 - Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm. Regardless of the level of disclosure provided by the firm to the public, management always possesses an advantage in the depth and breadth of knowledge concerning the real risks.

4 - Markets are usually in disequilibrium because of structural and institutional imperfections, as well as unexpected external shocks (such as an oil crisis or war). Management is in a better position than shareholders to recognize disequilibrium conditions, and to take advantage of one-time opportunities to enhance firm value through selective hedging (the hedging of exceptional exposures, or the occasional use of hedging when management has a definite expectation of the direction of exchange rates).

1. Purchasing or selling goods or services on credit when prices are stated in foreign currencies,

2. Borrowing or lending funds when repayment is to be made in a foreign currency,

3. Being a party to an unperformed foreign exchange forward contract, and

4. Otherwise acquiring assets or incurring liabilities denominated in foreign currencies

Funds are borrowed or loaned, and the amount involved is denominated in a foreign currency.

Transaction exposure arises from the payment of one currency to a party wanting, in the end, a different currency.

Thus a movement of currency value from one currency to another is required.

Foreign currency cash balances held for operating purposes by a foreign subsidiary are not inherently intended for exchange for another currency, nor is such an exchange required.

Forward contract

Money market hedge

Futures contract

Options contract

1 - the risk tolerance of the firm, as expressed in its stated policies

2 - the treasurer’s own view, or expectation of the direction (and distance) in which the exchange rate will move over the exposure period.

Many MNEs have established rather rigid transaction exposure risk management policies that mandate proportional hedging.

These policies generally require the use of forward contract hedges on a percentage (e.g., 50, 60, or 70%) of existing transaction exposures.

As the maturity of the exposures lengthens, the percentage forward-cover required decreases.

The remaining portion of the exposure is then selectively hedged on the basis of the firm's risk tolerance, view of exchange rate movements, and confidence level.

Measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change.

Potential for accounting-derived changes in owner's equity to occur because of the need to "translate" foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements.

Measures that change in the PV of the firm resulting from any change  in future operating cash flows of the firm caused by an  UNEXPECTED change in exchange rates.

The variance in expected cash flows arising from unexpected exchange rate changes.

Transaction

Translation

Operating