Foreign Exchange Risk Management and Hedging
Types of FX exposure
Candidates must distinguish transaction exposure (known or forecast foreign currency cash flows), translation exposure (accounting impact of consolidating foreign subsidiaries), and economic or operating exposure (long-run effect of rate changes on competitiveness and value). Each calls for different hedging approaches and horizons.
Hedging tools and policy
Common tools include forwards, FX swaps, options, and natural hedges such as matching revenues and costs in the same currency. A hedging policy should specify objectives, permitted instruments, hedge ratios, tenor limits, counterparty limits, and accounting treatment. Understand hedge accounting under relevant standards: cash flow hedges, fair value hedges, and net investment hedges, and the requirement for documented effectiveness. Know that hedging reduces uncertainty but can forgo upside and creates basis and counterparty risk.
Traps in questions
Frequent errors: treating translation exposure as cash flow risk; assuming a hedge must eliminate all risk rather than reduce it within policy; and forgetting that forecast exposures may not materialise, creating over-hedging. Watch for questions that present speculation as hedging because the instrument is a derivative.
Rule of thumb
Hedging addresses uncertainty about a known or expected exposure; speculation takes a position without an underlying exposure. If there is no underlying exposure, it is not a hedge.
Worked example
A UK exporter expects USD 1,000,000 in six months. It sells USD forward for GBP at the six-month forward rate, locking in sterling proceeds. If GBP strengthens, the exporter forgoes gains but is protected against GBP weakness; the hedge is a transaction-exposure cash flow hedge.