International Corporate Finance: Value Creation with Currency Derivatives in Global Capital Markets, + Website

CHAPTER 14

The Case for Foreign Exchange Risk Management

It is part of wise men to preserve themselves today for tomorrow, and not risk all in one day.

Cervantes

The ever-increasing integration of the international economy, coupled with the heightened volatility of foreign exchange (FX or forex) rates, has elevated managing currency risk from a tactical, functional assignment to a cross-functional and truly strategic management responsibility. Indeed, since the demise of the Bretton Woods system of quasi-fixed exchange rates in 1973, the international monetary system has experienced exploding exchange rate volatility coupled with periods of prolonged over- or undershooting of currency values, which tends to wreak havoc on strategic plans when they are laid on shifting sands. As one author notes allegorically:

[I]n this era of floating exchange rates, no business in the industrial world may consider itself insulated from currency risk. For if business is a war without bullets, then that war is increasingly fought on a floating battlefield. Imagine an army that struggles mightily to take a hill only to find that the hill, overnight, has turned into a valley, and the plain, out of which the enemy had been beaten, is now the high ground. Currency is such a battleground. Every company may be such an army.¹

Indeed, managers who continue to ignore foreign exchange rate risk are a rapidly disappearing species! Simply put, foreign exchange risk management refers to the proactive management ...