FX Risk Management and Hedging
Exposure types and hedge design
The exam tests how firms identify and hedge FX risk. Transaction exposure arises from known future cash flows in foreign currency. Translation exposure arises when consolidating foreign subsidiaries. Economic exposure is the broader effect of FX moves on competitiveness and long-term cash flows.
- Forwards: lock a rate and remove uncertainty, but also remove upside.
- Options: provide protection while retaining upside, at the cost of a premium.
- Swaps: manage the timing of cash flows or funding in another currency.
- Natural hedging: matching revenue and costs in the same currency reduces the need for derivatives.
- Hedge ratio: the percentage of exposure hedged. Over-hedging creates a speculative position.
Worked example
A EUR-based exporter expects USD 1,000,000 in 90 days. A forward at EUR/USD 1.1000 locks EUR 909,091. If spot at maturity is 1.0500, an unhedged conversion would yield EUR 952,381. The hedge gives up EUR 43,290 relative to that outcome, but it protects against USD weakness. The hedge ratio is 100% of the exposed USD 1,000,000; hedging USD 1,200,000 would leave USD 200,000 unhedged in the opposite direction and is no longer a pure hedge.
Traps
- Hedging translation exposure with short-dated transaction hedges.
- Over-hedging and calling the excess a hedge.
- Ignoring basis risk between the exposure and the hedging instrument.
- Treating VaR as a maximum possible loss rather than a probabilistic estimate.