Foreign Exchange Risk Management
Core concepts
FX exposure comes in three forms: transaction (known future cash flows in foreign currency), translation (accounting conversion of foreign subsidiaries), and economic/operating (competitive impact of rate moves). Hedging tools include forwards, futures, options, FX swaps, cross-currency swaps, and natural hedges (matching revenue and costs in the same currency).
Pricing and parity
Understand covered interest parity: the forward rate reflects the interest rate differential between two currencies. F ≈ S × (1 + r_domestic)/(1 + r_foreign). If the forward deviates, arbitrage exists. Know that purchasing power parity is a longer-run anchor and less reliable for short-term hedging.
Traps in questions
- Confusing transaction exposure (cash-flow) with translation exposure (accounting).
- Misquoting direct vs. indirect quotes and inverting the hedge direction.
- Assuming an FX option hedge is free-premiums have a real cost.
- Forgetting that a cross-currency swap exchanges both principal and interest, unlike a plain FX forward.
Worked example
A U.S. firm will receive €10M in one year. Spot EUR/USD = 1.10; U.S. rate 5%, euro rate 3%. Forward ≈ 1.10 × (1.05/1.03) ≈ 1.1214. By selling €10M forward at 1.1214, the firm locks in ≈ $11.214M. If it instead buys a put option on euros, it caps downside while retaining upside-at the cost of premium.
Rule of thumb
Hedge transaction exposure with forwards for certainty; use options when upside participation matters and the premium is acceptable.