Essay: Foreign Exchange Derivatives as a Risk Management Tool

The last three decades has been proved to be very fertile for the growth of foreign exchange risk derivatives. There are many reasons for this growth like the overall increase in the research in the domain of treasury. Secondly there is an increase in the global activity of firms which exposed them to the foreign exchange risks. Both of these factors forced the firms to make separate treasury department. Over the years they have developed many derivatives to hedge against the foreign currency rates volatility[1]. The growth is more prominent during the period of 1970 and 1980. Davis & Collier researched that in 1977, many companies of UK have set the separate treasury departments which are solely responsible to deal with the treasury functions and foreign exchange risk management[2]. Gilbert also found that the size of treasury departments have been increasing in the last decade because of the increase in the development of foreign exchange derivatives[3]. Most companies have appointed Chief Financial Officers (CFO) and increased the number of finance experts in their treasury department in order to take advantage of the financial instruments and lower down their exposure to the currency exchange risks.

Davis & Militello studied the US market and reported that similar trends are also found in US based Multinational Companies (MNC’s)[4]. The US companies have also deputed foreign exchange managers and junior treasurers who were supposed to report the Chief financial officers and treasury heads in the US companies.

Exchange rate risk is so much important that company sometimes have to take strategic level decisions in order to eliminate such types of risk. For example, firms can decide to outsource or shifting of the operating facilities to some other low cost countries to eliminate the factors of unpredictable variation in the exchange rate risk[5]. Where these types of decisions reduce the foreign exchanges risk factors, it also helped to increase the cost effectiveness and flexibility of production process of firms. One major obstacle in the use of currency derivatives is considered to be the complex accounting treatment. The accounting treatment of option contracts is very debatable issue and of greatest concern for the risk managers[6]. The basic dilemma is that when a firm uses the derivatives which are linear in their risk payoff profile, like swaps and forwards, to fix some risk of underlying assets, the position of derivatives itself appear to be an accounting loss[7].

[1] ibid

[2] Davis, E. W., and A. P. Collier. “Treasury Management in the UK.” Association of Corporate Treasurers, 1983.

[3] Gilbert, N. “More financing goes global.” Management Review, 1987: 26-31.

[4] Davis, H. A., and F. C. Militello. “Foreign Exchange Risk Management: A Survey of Corporate Practices.” Financial Executives Research Foundation (FERF), 1995.

[5] Adam-Muller, A. F. A., and K. P. Wong. “Restricted export flexibility and hedging’. (working Paper).” Center of Finance and Econometrics, University of Konstanz., 2002.

[6] Bodnar, G. M., and G. S. Hayt & R.C. Marston. “1998 Wharton survey of financial risk management by US nonfinancial firms.” Financial Management, 1998: 70-91.

[7] ibid

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