Foreign Exchange Exposure and Risk Management
What the exam tests
Foreign exchange exposure and risk management tests transaction, translation and economic exposure, and hedging with forwards, futures, options, money-market hedges and swaps.
Core rules
- Transaction exposure affects known foreign-currency cash flows; translation exposure affects reported financial statements; economic exposure affects long-run competitiveness.
- Covered interest parity: forward rate ≈ spot × (1 + domestic rate)/(1 + foreign rate) for the period.
- A money-market hedge borrows/invests in the two currencies to lock in a domestic-currency amount; compare its all-in cost with the forward.
- Currency options hedge downside while retaining upside, but the premium is a sunk cost; compare hedged and unhedged outcomes.
- Netting, matching, leading and lagging reduce exposure internally before derivatives are used.
Worked example
An Indian importer owes USD 1 million in three months. Spot = ₹83/USD; three-month forward = ₹83.50; INR interest = 8% p.a.; USD interest = 4% p.a. Forward cost = ₹8.35 crore. Money-market hedge: invest USD 1m/1.01 = USD 0.9901m at 4% for three months, costing ₹8.218 crore at spot. Borrow ₹8.218 crore at 8% for three months; repayment = 8.218 × 1.02 = ₹8.382 crore. The forward is cheaper by ₹3.2 lakh, so use the forward.
Traps
Using the wrong side of a bid-offer spread; annualising a three-month rate incorrectly; forgetting option premium; treating translation loss as a cash-flow hedge; ignoring that forward rates may include a liquidity premium, not just interest differentials.