MANAGING TRANSLATION, TRANSACTION AND ECONOMIC RISK EXPOSURES

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MANAGING TRANSLATION, TRANSACTION AND ECONOMIC

RISK EXPOSURES

1. Translation Risk Management

1.1 Understanding Translation Exposure

Accounting exposure or translation exposure is the third type of exposure that arises when an

MNC translates or conveys the financial statements of its foreign subsidiaries into its reporting

currency. This is important for the contending companies since it enables an assessment of their

financial position other than the specific country they are situated in. However efficiency comes

with the following disadvantages, mostly because of the fluctuation in foreign exchange rates.

This process is central because when a parent company prepares its consolidated statements

based on Foreign subsidiaries’ books of accounts, an important step called ‘Consolidation’,

requires conversion of the said books from the domestic currency of the subsidiary to the

reporting currency of the parent. This includes the process of converting different balance sheet

items like assets and liabilities, statement of operations items like revenues and expenses, and

other items from foreign currency to the functional currency at current or historical rate based on

the first or the current rate method. The two main techniques in the business valuation are the

current rate method and the temporal method. The current rate method translates overall balance

at that rate which prevailed at the balance sheet date, while the temporal method translates

monetary current assets and Liabilities at the current rate but non-current assets and liabilities at

the historical rate.

After translations are done, there is bound to be either a gain or a loss arising from the

fluctuations in exchange rates. For instance, where the reporting currency has appreciated against

the foreign currency, the amount of foreign assets reported is lower by declining foreign

currency values hence the effect of foreign assets on the net worth of a parent company is

minimized. On the other hand, if the reporting currency falls in terms of its value, the values of

foreign assets, when translated into the reporting currency, will rise, an added boost to the net

worth. These are usually captured in a part of shareholders’ equity called cumulative translation

adjustment (CTA). (Shapiro, 2014). Translation exposure, per se does not impact cash flows but

can exert tremendous pressure on key financial ratios, and would create an impression of

instability. These translations are closely watched by investors and analysts since changes in

translations which can bring in translation gains or losses can actually worsen or improve stock

price valuation. Hence, protecting against, identifying, and measuring translation exposure is an

essential precaution for MNCs today. Measures used to address this risk include balance sheet

hedges, where organization running foreign operations tries to offset the effects of exchange rate

moves through matching the assets and liability in such currencies, and natural hedges that are

done through organizational changes such as distribution of operations and sourcing to naturally

hedge the exchange risks (Madura, 2021). The topic of translation exposure therefore forms one

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of the key informative areas of financial reporting of the multinational companies due to the

requirement to consolidate the statements in the different currency. Managing such exposure is

beneficial in as much as it assists in keeping the financials and overall investor confidence intact

amid fluctuating exchange rates.

1.2 Translation Risk Measurement Techniques

Accounting exposure also commonly referred to as translation risk results from the consolidation

of the statements of operation of foreign subsidiaries of a firm in the reporting currency of that

firm. In order to determine the appropriateness of this risk, it is paramount to recognise how it

can be quantified. Some of the techniques used to estimate translation risk include Current rate

method and temporal method; these methods have individual impacts on the statement of

financial statement.

The Current Rate Method

The current rate method means that all the assets and finance and liabilities have to be translated

at the current exchange rate as that of the balance sheet date. Under this method, all forms of

revenues and expenses are translated with the help of the exchange rate that is in existence at, or

the average exchange rate corridor of the period under consideration, in cases where numerous

and frequent transactions occur during the period. This method is advantageous because it

attained a more near value of the firm’s foreign subsidiary’s balance sheet, recognizing the

present day economic reality. In the aspect of economic repercussions on the value and structure

of ever crucial financial statements, we get some factors into_light in the subject of foreign

subordinate. Initially, there is a conversion under Balance Sheet Translation where all the assets

and liabilities are translated using the closing rate. This adjustment seeks to present a more

credible value of the foreign subsidiary during preparation of the corporate statements in the

reporting currency of the parent company. In the case of basic financial statements, the Income

Statement, all the revenues and expenses are translated using the average exchange rate during

the period. This assists in averaging out any sharp movements which may be evident within the

span of the given period and hence aids in providing a flat form of the financial performance.

Equity Section is the next discussion but before that one more vital aspect comes into the picture

in the form of cumulative translation adjustment (CTA). This is an adjustment that lies under the

equity section in the balance sheet and its role is to quantify the effects of exchange rate

fluctuations on the net assets of the foreign subsidiary. As such, when exchange rates change,

this may result into changes on the equity section; an aspect that could possibly alter the overall

equity figures presented in the parent company’s reports (Eiteman, Stonehill, & Moffett, 2019).

It becomes important for organizations with overseas branches to not only study these effects

also to be able to control them in their global processes in order to provide the shareholder with,

true and fair view.

The Temporal Method

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Temporal method- also referred to as historical rate method, cash and bank balances, receivables

and payables are translated at the current rate while inventory, property, plant, and equipment are

translated at the past rate. The revenue and expenses are a translation by the exchange rates at the

date when the income and expenses were recognized. Regarding the extent of high risk affecting

the financial statements in the area of foreign currency transactions, it is namely possible to

identify various factors. Starting with the Balance Sheet, there is an emphasis on converting the

means of this statement, in particular, the method for handling such or such kind of items. While

determining the stuff, monetary items are normally translated in accordance with the current

exchange rate while non–monetary items are translated by the use of the historical exchange

rates. This approach can lead to unequal valuation of assets and liabilities causing distortion in

the actual picture of financial situation of the company due to inaccuracy in the present market

cost due to use of past rates. Going to the Income Statement side, The translation of revenues and

expenses is done with a lot of respect to whether they entail monetary or nonmonetary features.

While monetary item–related transactions are often translated utilising the rates prevailing in the

period the transactions occurred, the non-monetary item – related amounts remains based on

rates most probably historical. As a result, a discrepancy arises as to the way the rate is applied,

and this leads to differential gains or losses based on the mismatch of translation techniques

adopted on related items. In further extension to the Income Effects, what is analyzed is the fact

that changes in foreign exchange rates are recognised in the net realised income with gains or

losses arising there from in the form of remeasurement. These gains or losses are taken to the

income statement; thus, they induce volatility in the company’s earnings. Consequently,

exchange rate changes impact the reported net income figures as these nominal measures work to

affect the company’s financial performance (Madura, 2021).

Comparison and Impact

The current rate method is usually demanded by IFRS rules for operating in foreign conditions

for subsidiaries and seemingly offers a more accurate reflection, given the most up-to-date

exchange rate. The temporal method is usually applied where it is accounted for under U. S.

Generally Accepted Accounting Principles (GAAP), for integrated subsidiaries. Financial

reporting is a major objective of both methods; however, the two methods get there from two

different angles. Another difference between the current rate method and temporal method is that

the former concentrates on the current market prices while the latter depends on costs incurred at

the time of acquisition.

1.3 Mitigation Strategies for Translation Risk

Balance Sheet Hedging

Focusing on the balance sheet, which is also known as accounting hedging, entails the alteration

of the book value and the currency composition of assets and liabilities to compensate for

exchange risks. The overall objective is to provide an organic hedging of foreign currency risk to

counterbalance the effects on the parent company’s consolidated balance sheet. To prevent

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exposure to exchange rate risk, organizations engage in the following: One of the most common

methods is asset-liability matching. This means that receivables and payables in foreign currency

should be offset in a company’s balance sheet to minimize risk exposure. For example, if a

company has the investors in its subsidiaries outside the country or operating in foreign countries

they can choose to use foreign currency loans to fund their investments. This strategic choice

makes sure that if the foreign currency depreciates, the effect on both the value of assets besides

liabilities is neutralized since it affects both in the same proportion thus; lessening the net fray of

translation in the statements. Another strategy of post-reform privatization patterns is to use

foreign currency debt. The global revenues may be finer in any currency that the investor desires,

however these multinational corporations can opt to issue their debts in the same currency as

their foreign operations. In this manner, the currency of the debt corresponds with operations of

the subsidiary, thus moderating what is known as the net assets translation risk of foreign

currencies.

Thus by taking up these strategic steps and by accurately matching its asset–liability structures

and its debt instruments to its foreign currency exposures, a firm is better able to meet the

unsettled aspects relating to exchange rate changes threatening its financial wellness and

enhanced its strong reaction in the increasing globalization of business environment. Thus,

currency hedging is effective in managing and reducing the risk of foreign exchange in the

financial market on one hand and it has also its limitations for users on the other hand. Another

clear benefit measured in accrual accounts is the net exposure which provides some stability to

the consolidated balance sheet of the Group Company by diminishing the effect of foreign

exchange movements. This is due to the fact that financial position of a company can easily be

anticipated even if there are fluctuations in international currency markets. Also, currency

management strategies may be made to meet the exotic currency risk maturity of a particular

firm so that an improved approach to risk management could be adopted. But at the same time,

managing currency risks and the application of hedging activities have their set of disadvantages

as well. One challenge that prevents most hedge funds from experiencing long-term success is

the fact that the hedge position requires fine-tuning on regular basis due to high volatility.

Moreover, conversion of currency hedges, often involves numerous sub-processes that under

normal circumstances may be time-consuming and cumbersome to manage. Two crucial

processes are involved due to which hedging must be continuously monitored and rebalanced as

pointed by Shapiro (2014); these include the high susceptibility to incurring losses and

determining its effectiveness.

Natural Hedging

Natural hedging is the process of organizing operations to achieve commodity-hedging results

without directly utilizing hedging devices. Hedging is also used in a way that makes the risk

management part and parcel of a company’s operating decisions with respect to currency. The

use of such measures is very important in order to limit risks emerging during operations on the

international level and related to the shifting of a currency. There are usually three standard tried

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and tested techniques of cognitive operations that include diversified operations, intra-company

operations, and pricing techniques. Diversification means the process of transitioning a

company’s business activities to other countries and dollars. Through the implementation of

practices such as the use of foreign currency cash flows through operations yielding sales and/or

through operations giving rise to costs, firms are thus able to mitigate currency risk. For instance,

a manufacturing firm that operates in Europe and is mainly distributing is products within

European countries would have both their costs and income translated in Euros. Such an

alignment renders the need for currency conversion to be quite rare, and thus the impact of

translation risk is significantly minimized, as changes in exchange rates lead to slight shifts in the

company’s financial configuration. Intra-company transactions are another useful tool in

currency hedging, they are also considered effective. Through such operations, firms perfectly

manage foreign currency flows through and through and with different subsidiary or divisions of

a particular firm. For example, a company based in America that owns a branch in Europe would

prefer sourcing the raw materials from European providers, which it can pay for using Euros.

This way they assist in harmonising the currency denominations with organisational revenue, for

instance, the euro sales revenues and hence, decreasing the necessity of off balance sheet

hedging tools and the consequence risk exposure is minimised. In addition to promoting cost

advantage, pricing strategies are equally significant in determining the manner to deal with the

risk of currency fluctuation. Managers and investors should understand that changing the value

of currencies is always predictable and can develop strategies for the becoming of a company to

be less affected by such changes. For instance, in international operations, companies may opt to

fix certain prices in local currencies rather than in home currency. In this regard, it is also

possible to witness contracts that contain clauses which enable tariff variations in view of

variations in exchange personnel. These options of contract pricing assist firms to have higher

fluidity in dealing with exchange risk and enable them to work and earn their profit within the

increasing and decreasing global markets.

Firstly, it was noted that through natural hedging dependence on financial instruments generally

applied to hedge can lead to lower hedging costs. In this case, the currency risk management

should be incorporated into the overall corporate strategy and management hence resulting to

improved affordability and sustainability of the management of translation risk. Such a structural

alignment ensures that the management of currency risk is included as an organisational firm

strategy than just a financial activity. However, natural hedging also has some drawbacks, apart

from the opportunities presented by these monetary impacts. As one of the hindering factors, it is

essential to consider that this organisational structure may restrict operational flexibility to some

extent. This means that since decisions are premised on the currency risk, the operational

freedom or the general decisions that companies make may seriously be limited. Sources noted

moreover that any successful natural hedging exercise needs a closer and coordinated planning

and implementation effort across multiple business units. It is necessary to explain that these

coordinates are crucial given the fact that operations must be structured to be naturally hedged

against the currency risks. Thus, with regard to natural hedging’s advantages, meaning the ability

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to act free of the reliance on complicated financial instruments and relying upon the principals of

business activity, it also has its obstacles to be faced: the issue of operational flexibility and

interaction. It is therefore possible to state that by drawing attention to these issues, businesses

can fully reap from natural hedging while avoiding some of the pitfalls associated with the risk

processes to giving their currency risk management a boost.

In balance sheet hedging, firms are in a position of effectively managing translation risk by

identifying the instruments that can be used to hedge the exposure. Balance sheet hedging when

used can directly net out or eliminate the specific currency risks through financial adjustment and

help to stabilise the financial statements. On the other hand, natural hedging involves

incorporating the risk management schemes into operation issues, which can be viewed as a

more effective one. Each of these approaches can be effective depending on the requirements

and goals of the company: sometimes it is better to weight more towards the complex models,

whereas in other cases the emphasis is placed on the simplicity of the models and the cost of

their calculation.

2. Transaction Risk Management

2.1 Identifying Transaction Exposure

Transaction exposure results from particular foreign transactions as for importation, exportation,

or undertaking to borrow or lend in foreign currency, it is the determination of the probability

that a change in exchange rate may affect the value of the future cash flows of a company.

Therefore, commitment to learning on how to analyze for transaction exposure is important so as

to enable these multinational companies avoid the exposure risks.

Identifying Transaction Exposure in Imports and Exports

To elaborate, when a business or an organization order good or services from another country

they would normally undertake to pay in a specified currency of the supplying country. This

leads to transaction exposure since the amount payable in the home currency at a later date is not

constant due to the exchange rate. For instance a US organization trading machinery with Japan

will purchase the equipment through payment in yen. They become costly to procure through the

foreign exchange markets if the yen appreciates significantly against the dollar before payment is

made (Madura, 2021). Likewise, in the same way, when generating goods or services, or perhaps

using some products, it comes across a scenario where the payment has to be made in the buyer’s

currency. This also gives rise to transaction exposure because the receivables become more

valuable or less valuable depending on the fluctuating exchange rates. For instance, a European

company which exports their products to the U. S. may use dollars when preparing the invoice.

The first loss occurs when the dollar trades lower against the euro before receiving the payment;

this means that the company will earn less euros than it estimated, hence lessing its revenue in its

domestic currency (Shapiro, 2014).

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Identifying Transaction Exposure in Borrowing and Lending

In essence, when a firm borrows in a foreign currency, it develops a claim on a foreign currency,

which implies that the corporation will have to settle that claim in the same foreign currency.

This means that in either case, the repayment cost rises whenever the home currency values in

relation with the foreign currency rises. For instance, a loan taken by a Brazilian company with a

dollar, the repayment cost will be relatively expensive in Brazil Reais if dollars has appreciated

(Eiteman, Stonehill, & Moffett, 2019). On the other hand when a company borrows in foreign

currency then that holding is an asset that will be paid in that currency. A depression in the FE

remunerations in relation to the homeward currency reduces the repayment value as well. For

example, consider a scenario where a Canadian firm extends a loan in euros to a European client;

this firm will be receiving euros as cash flows when repaid by the European client; a depreciation

in the euro relative to the Canadian dollar has an impact on the elicited cash flow in the firm.

Steps to Identify Transaction Exposure

Competitive markets of today’s globalized economy entail various ways of conducting foreign

exchange transactions in businesses. Whether it is about selling, buying, borrowing or investing

these transactions not only involve the main subject: goods, services or monetary amount. In the

context of shifting international markets, it is possible to identify the chances of every

organisation to be affected by the concept of transaction exposure. The first process in this

strategic maneuver is to undertake a sectors and transactions mapping to identify all transactions

that involve foreign currencies. Therefore, by capturing the broadest horizon of interactions in

financial contexts, across borders inclusive, businesses are guaranteed an acknowledgement of

all possible risks. Starting from distinctly business-like activities such as mere sale or purchase

of a product, to relatively involved business ventures of investment and share prospecting, each

and every engagement may/will be adduced to be in a prima facie position to be impacted on by

tendencies in exchange rate differentials. Hence, a careful review at this stage of planning is

critical in establishing a strong risk management framework in the project. Next, focus shifts to

the identification of each foreign currency transaction’s cash flow, at which point they occur.

The evaluation of temporal dynamics concerning payments and receipts whether immediate in

the short run or in the far future highlight the most crucial information any organization needs to

perceive the stability of its financial structures. However, for a proper understanding of

transaction exposure, there is an important element, which is the analysis of the currency pairs

that tends to be used in each transaction. It is also important to note that not every currency is

exposed to volatility in exactly the same manner; some pairs are more volatile than others, which

means that the level of exposure can be said to be higher.

Thus, by studying past trends and future tendencies of the base of the currency and quote of the

currency of two countries, enterprises can get an idea of the level of risk involved in the business

and take necessary precautions to reduce the loss. It is important therefore to establish a routine

that would help eliminate risk factors and enable efficient risk management. Daily updates

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regarding the currencies’ fluctuations are useful in raising alarm early enough so as to facilitate

appropriate shifting of hedging policies and operational strategies.

2.2 Hedging Transaction Risk

Forward Contracts

Sometimes, contracts are entered into whereby both parties agree to exchange a specific amount

of foreign currency at a set price in the future but at a future date only. These contracts have

flexible lessor and more specific contracts between the company and a financial institution

because it provides a precise hedge that the company requires. As we have seen, forward

contracts are long-term, self-regulating contracts which provide numerous advantages and

difficulties to the parties involved. On the benets side, they enable businesses to get a certain rate

for the future times in advance, which makes it possible to be certain about the future cash flows

and shield themselves against unfavorable exchange rate changes. Also, such contracts can be

adjusted to correspond to the bills and its reciprocity in the foreign currency thus delivering

specific risk hedging (Madura,2021). They rule out the potential to gain from movements in

exchange rate in a positive direction – and have no built in appreciation potential. Also, there is

credit risk in these contracts since the counterparty may not be able to meet its obligations

despite the risk being relatively controlled due to the participation of sound financial entities

(Wilson, 2018).

Money Market Hedges

Money market hedges are used to use the money markets of country and other country within the

organization to prevent foreign exchange fluctuation on future transactions. Managing and

hedging money market is a completely different concept for receivables and payables where the

following strategies are used. As for receivables assets, a company can borrow in foreign

currency now, then exchange it for home currency, then repay the loan once they have collected

their receivables. For payables, the company can borrow the home currency with an equivalent

amount of the foreign currency and then utilize the investment to pay the payables when they

become due. Flexibility is another advantage of money market hedges in a way that hedges can

be set according to the transaction sizes and time that is needed, and counterparty risk; which is

usually present in forward contracts (Shapiro, 2014). But it is here that these hedges are brought

with some difficulty. They can be off complicated, one need to understand the domestic as well

as the foreign money markets and their effectiveness depends on the interest difference between

the home currency and the foreign currency and quite often it may becomes a costly affair .

Options

Currency options allow companies to take on the option to sell at a specific rate and price at any

time on or before a certain date. There are two main types: known as call options which refers to

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the right to buy the underlying asset at a specific price on a particular date as well as put options

which refers to rights to sell the underlying asset at an agreed price on a particular date. Swaps

are less favorable than options for the hedger but more favorable for the currency user. They give

protection against unfavorable currency movements as well as enable shareholders to be in a

position to enjoy the advantages resulting from movements in the specific currency. But, it is

crucial to know that options are thrice as risky as physical ones as they come with a list of

disadvantages given below. They often call for premiums to be paid and some can be large and

hence they may reduce the effectiveness of the hedge. Additionally, control and appreciation of

options may not be easy as they involve a certain level of skill and expertise.

There are advantages and disadvantages that come with this type of hedging: forward contracts

are straightforward and provide a guaranteed price, but the downside is the absence of the

opportunity to gain more in case of a favorable market shift. Money market hedges make futures

contracts more flexible and can reduce the chance of counterparty default; however, money

market hedges themselves may have more counterparty risk and can be expensive and difficult to

manage. Options are an intermediate form of investment that enables protection when the

unfavorable moves are expected but also enables benefits from the favorable movement;

however, options are accompanied by premium costs and contract complexities.

2.3 Evaluating Hedge Effectiveness

Thus it is important for MNEs to frequently assess the performance of managing transaction

exposure in order to determine the efficiency of hedging strategies undertaken. Two major

techniques used in this assessment are the Value at Risk, or simply VaR, and the cost-benefit

analysis.

Value at Risk (VaR)

VaR on the other hand aptly refers to a statistical measure which calculates potential losses that

can occur on an investment portfolio for a given time horizon within a fixed level of confidence.

It is commonly incorporated in risk management, to measure a firm’s vulnerability to

unfavourable fluctuations that may arise in the market.

Steps to Calculate VaR

The first step to VaR calculation is the definition of the portfolio, the total portfolio values in the

form of assets, liabilities, and foreign currency positions. Then, define the time horizon and

confidence coefficient; the time horizon is usually set for one day, one month or one year; in

terms of the confidence coefficients the figure is chosen 95% or 99%. For the historical method,

there is the use of past exchange rates in an attempt to deduce how changes in portfolio value

may be impacted: Historical exchange rate changes are estimated and applied to the

current/simulated portfolio. One of the approaches is the variance-covariance method, which

prescribes the assumption of normal distribution of the returns, the computation of standard

deviation of the exchange rate changes and multiplications of this figure to arrive at the estimate

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of potential losses. Using the historic data of exchange rate fluctuations, the Monte Carlo

simulation creates many exchange rate plans and predicts how real portfolio value will fluctuate

and what kind of loss may be incurred.

Consequently, while conventional measures of risk management offer different approaches in

managing risks, VaR has the following benefits: gives a clear indication of the measures of risk

exposure by calculating the exposure to risks in monetary terms; helps one understand the

possible losses and quantify them because VaR gives a precise quantified value of risk exposure.

However, VaR has some weaknesses, or it relies on distribution of returns which tend to have

normal distribution, not always.

Cost-Benefit Analysis

Cost-benefit analysis can be professionally defined as a comparison of the costs associated with

hedging to the benefits ensuing from the mitigation of exposure to exchange rate change.

Steps for Cost-Benefit Analysis:

To determine the net benefit of a hedging practice, need to be able to recognize all hedging costs,

such as option premiums, forward contracts, money market hedge interest rates, and other

expenses incurred during the hedging processes. Subsequently, assess projected direct and

indirect cash flow exposure possible through quantitative data gathered from traditional

approaches in calculating exposure and historical data. After that, specify gains of hedging as it

is possible to estimate the degree of hedge impact on limiting possible losses ; estimate how

much the chosen strategy decreases the fluctuations in cash flows or in the financial statements.

Last but not least, using the overall hedging cost index, calculate the overall net gain of the

hedging strategy as the difference between the total potential losses avoided and the total

hedging costs.

On balance, cost-benefit analysis has the following advantages and downfalls when used for

hedge evaluation: Firstly, cost-benefit analysis offers a concrete financial rationale for hedging

activities and could be a tool in managerial decision-making regarding the implementation of

hedging strategies or their modification because it sheds the light on their efficiency or

inefficiency. But, it may entail some or all of the mentioned steps: Besides that, it is a time-

consuming and data and assumption-sensitive process. This might also not capture the volatility

and the overall nature of the currencies market as well as possible shocks that may occur in the

market (Shapiro, 2014).

3. Economic Risk Management

3.1 Defining Economic Exposure

Economic exposure becomes possible as exchange rate fluctuation puts a firm in different

position concerning competition. It can lead to changes in revenues and costs which may impact

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the overall market value of the firm in the long run. When compared to the buying and selling in

the immediate functional currency, economic exposure is more about the effects on the future

cash and competitive positioning of the firm.

Key Factors Contributing to Economic Exposure: Key Factors Contributing to Economic

Exposure:

Fluctuations in exchange rates present severe impact indicators that affect various aspects of

firms’ processes and functioning. Firstly, they are capable of profoundly influencing the

competitive advantage of first domestic and then foreign competitors by changing the relative

cost factors. For Instance, appreciation of the dollar and a subsequent depreciation of the euro

makes products made in Europe cheaper and it can consequently reduce the competitiveness of

firms in the United States. Secondly thru changes in foreign exchange rates this leads to changes

in price matters in order to sustain the market share and the profitability of the company. To

sustaining sales volume for exporters, a stronger domestic currency may force them to slash their

prices; this leads to lower profits. Thirdly, fluctuations in exchange rates affects the cost structure

because costs may be affected by combining inputs from various currency areas. A favorable

movement in the supplier’s currency can increase its input costs and thus exert pressure on the

firm’s profit margin. Lastly, fluctuations in currency position impave on the buying power of the

consumers and demand where by a weak domestic currency makes the exports to be more

attractive to the foreign buyer thus increasing the sales while a strong domestic currency has an

opposite effect.

Measuring Economic Exposure

Evaluating economic exposure therefore implies the assessment of the way these exchange rate

changes might have an impact on the future cash flows of the firm and its market value solution.

This can be done through various methods, such as: The following examines various methods

that can be used in measuring currency risk. Sensitivity analysis working under the umbrella of

operational management revolves around testing how changes in exchange rates affect the firm’s

cash flows, revenues, and costs under different circumstances. Risk analysis apply statistical

models on the past data to determine relationships between the exchange rate volatile movement

and firm’s market value or cash flows. Competitive analysis considers impacts of fluctuations in

currency on competition such as suggesting prices and costs of the competitors to base over.

Mitigating Economic Exposure

Firms can employ several strategies to manage and mitigate economic exposure: For firms to

manage Currency risk the following mechanisms can be applied. Distribution of operations as

well as markets means that risks are spread and reduced because there will be little or no

concentration of operations in one particular currency, which is very vulnerable due to exchange

rate fluctuations. Other measures that can be taken to minimize this exposure include

Corresponding adjustments on the operating side; for instance, synchronizing the production and

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supply chain plans with the costs and revenues of the same currency; it can be possible to source

materials in the market of the selling goods. Hedging transaction exposure may be combined

with more sophisticated approaches concerning instruments like currency swaps and options, and

being more complicated than the former, carries comprehensive insurance against long-term

currency risks. Similarly, strategies of creating a variable pricing structure that can be altered on

account of currency movements also serve in an apt fashion to sustain competitive pricing while

considering margins (Eiteman, Stonehill, & Moffett, 2019).

3.2 Assessing Economic Impact

Evaluating the long-run strategic effects of changes in exchange rate upon a firm’s position in

the global markets and its market capitalization is quite a daunting but crucial activity for firms

that operate across national borders. This process involves several methods, where each one

gives understanding of the way by which fluctuation of exchange rates impacts on the firm’s

stability, demands in the market and the financial result in the subsequent period.

Sensitivity Analysis

Sensitivity analysis is used in forecasting that focuses by determining the impact that a change in

the exchange rates will have on the net operating cash flows, the revenues, and the total costs of

a firm. This can involve developing a number of mock scenarios whereby one of them assumes

different exchange rate and then measuring the effects on the financial position. Starting with, it

is necessary to identify those factors involved in deriving revenues, costs, and margins that are

sensitive to exchange rate movements. Therefore, various exchange rate assumptions, ranging

from the worst-case to the best-case exchange rate, are developed. Some gains accrue to the

process of scenario analysis, they provide management of scenarios, which aids when planning

for different forms of exchange rate conditions. It also provides insights into the specific

financial fields most exposed to fluctuating exchange rates, which brings us to rationalized risk

management.

Econometric Modeling

Econometric modeling entails developing large-scale models – or large system econometric

models – comprising many economic variables to analyze and estimate adjustments of rates and

their effects on the financial performance and market value of a firm in the long-run. It is also

important to stress that separating currency risk management is the first step in the risk

management process and follows several steps. First of all, an Econometric model to be built

involving exchange rate, interest rate, inflation rate and economic growth is identified. Then,

using this model, more simulations are carried out with variations in economic conditions and

movements and exchange rate included. Finally, based on the mathematical model, a forecast to

determine the financial effects that will occur in the long run is established, and constant

updating of the model is done whenever new data emerges. The following are advantages of this

method; Firstly, it introduces the interrelation of a number of economic factors with exchange

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rates to give an all-inclusive view of the way they affect the firm and its financial performance. It

proves useful in the long-term strategic forecasting whereby the firm will be in a position to

make informed decisions in case of currency risk advances.

Real Options Analysis

Unlike the traditional net present value approach that ignores the uncertainty of the decision-

making environment, real options analysis model considers investment opportunities as financial

options whereby an investor has the right but not the obligation to enter into an agreement to

purchase or sell an underlying at a specified price and time by developing a contingency plan for

managing the exchange rate risks. The process and situations regarding exchange rate related

decisions therefore require some structure. Firstly, the major investment programs and the

important strategic decisions dependent on exchange rates are determined. Following this, the

expected performance of various strategic decision using different exchange rate forecasts, is

evaluated to determine the possible implications. This final evaluation enables a decision to be

made depending on the incoming exchange rates as a form of investment or whether expansion

or contraction is required. The advantages of this method are quite remarkable First of all, it is

possible to indicate the ability we gain to make suitable interventions designed at helping those

who need it most. Firstly, it makes it easier to make strategic decisions regarding operations in a

foreign country because it is flexible to changing exchange rate conditions. Moreover, it helps in

measuring the value calibrated to coping with uncertainty of exchange rates which in turn

improving risk management.

Regression Analysis

Regression analysis entails quantitative evaluation of past data, thereby showing the correlation

between the exchange rate fluctuations and the value of a firm or its cash flows. In testing the

hypothesis on currency risk, a logical approach that is structured is employed. First, data on

exchange rate, firm’s revenue, cost, values of its stock and others of the historical periods are

gathered and examined very carefully. Secondly, regression model is defined, which describes

the dependence of a dependent variable, for instance, the market value or revenues, on

independent variables including exchange rates. Using advanced statistical packages, estimates

of the coefficients are then made and this assists in establishing the extent to which the

relationship between the dependent variable and exchange rate movements. The use of this

method has the following advantages; Providing measureable data on the role of exchange rates

in the companies’ financial performance, which inturn helps to better determine the conditions

for managing currency risks. It further aids to gauge the extent of the risks to the firm due to

currency fluctuation so as to pave way for a good strategies in risk management.

Competitive Analysis

Competitive analysis allows for the identification of changes in the makeup of competition that

occur due to volatile exchange rate factors. This includes analysing how fluctuations in currency

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impact on Company and competitor cost models and in particular the price proceeds which are

taken. The main steps involved in conducting a good analysis on currency risk include; First the

industry environment scan is carried out in an endeavor to analyze competition and select major

players in global currency zones. After this, a cost and pricing synthesis is done to determine the

impact of foreign exchange volatilities on the cost position and pricing strategies for the firm and

its competitors. Next it measures the implications of changes in competitive positioning that

occur due to the exchange rate movements in relation to market shares and profitability. As a

result of engaging in this analytical process, various advantages are accorded as follows.

Secondly, they give an understanding of exchange rates and their effect on different markets as it

allows consideration of competitions taking place on different currency areas.

3.3 Long-term Risk Strategies

Economic risk management includes activities based on business and financial planning to

reduce long-term exchange rate risks’ effect on a firm’s cost position and shareholder value.

Operational Strategies: Diversification

Thus, diversification is considered to be one of the most important operational strategies in

business. This makes it easier for firms to diversify their operations which can help to cut down

risks associated with operating in a certain geographical region or a certain currency. It also

mean that it is using this geographic diversification that even if there are some movements in

some currency or certain market is not so good then it is overcome by positive movements in

another market. Similarly, product differentiation in which a firm engages in between producing

and selling a variety of products in diverse markets also minimise risks. For example, a company

that deals with imported luxury products and locally produced essential food items will realize

that while changes in the currency of foreign exchange affect the demand of luxury products, the

demand for essential food items does not suffer the same fate, thereby tallying off the overall

impact of the issue on the company’s profitability.

Financial Strategies: Strategic Hedging

Managing long-term currency risk is part of strategic risk hedging whereby forecasts are made

on the future change in exchange rates. While transactional hedging targets specific short-term

exposures, strategic hedging targets the total economic exposures that are likely to bring a

discount or a premium on the value of a firm in the financial marketplace. Currency derivatives

are commonly used to control and hedge exchange risks with such popular forms as currency

swaps where firms exchange local currency cash flows for another at fixed future dates at certain

fixed rates. Furthermore, operational hedges such as Strong currency matching where firms

match their revenues from foreign sales with costs in the same currency. For instance, a company

based in the United States which has large business operations in Europe may need to set up

production plants in Europe which have revenues and costs in euros; this in effect hedges net

currency risk. Another change is to transform the financing structure, involving loans in those

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currencies in which the specific firm uses a large number of revenues, hence matching the flow

of revenues to such loans.

4. Currency Risk Analysis

4.1 Types of Currency Risk

This kind of risk is sometimes referred to as exchange or currency risk and is as a result of

changes in the price of a particular currency in relation to another currency. Thus, the given risk

can affect businesses in different aspects depending on their activities and operations with

foreign currencies. Transaction risk is the risk exposure in the foreign exchange market involved

in buying or selling goods and services with a foreign company, while translation risk has to do

with the conversion of accounts into the reporting currency when preparing financial statements.

Transaction Risk

Transaction risk arises where the company enters in to a business transaction, which is in a

foreign currency. This risk is associated with change in exchange rate between the time a

transacted is made and the time the transacted is completed.

Implications to Businesses

It is well noted that the changes in the exchange rates are not easy to handle as they come with a

number of issues. Also such fluctuations create unpredictable changes in the prices for imports

and the value of exports – things that can complicate the processes of financial planning.

Secondly, pressure on profit margins comes into force if the company cannot transfer the

bumped up costs on to the customers or if it earns less revenue from its operations in foreign

exchange translated into the domestic currency. These reductions of profit margains make

financial instability worse as well. At the same time, instability in foreign currency exchange

brings in uncertainties in cash flow and budgeting of the business and other related finances.

Customers’ cash flow variabilities can potentially disrupt businesses’ capacities to control and

regulate costs, and protect funds appropriately for the payment of required functions and services

at the proper time.

Translation Risk

This is because the risk of translation arises where there are foregoing operations such as,

subsidiaries that carry out operation in a foreign language different from the parent company’s

reporting language. Substantially, this risk stems from the process of translating the financial

statements of these subsidiaries from their functional currency into the reporting currency of the

parent company.

Implications to Businesses

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Fluctuations in value of foreign currencies affect many other aspects and elements of the

financial statements. Firstly, it makes the companies suffer from substantial changes in reported

assets, liabilities, revenues, or expenses, and thus affects their ratio calculations. Furthermore, the

values in shareholders equity section might fluctuate over a period of time because of change in

translation adjustment and affect the state of the company’s financial steadiness as shown in the

consolidated statement. It therefore becomes difficult to evaluate the performance of subsidiaries

and their performances.

Economic Risk

This is also referred to as an operating risk or economic risk, as it depicts the long-term impact of

fluctuating exchange rate on the overall market value as well as competitive prospects of an

organization. Thereby, exchange rate risk impacts a business firm’s future cash flows and its

market share due to fluctuations in exchange rates over time.

Implications to Businesses

Exchange rate volatility impacts businesses in multiple ways since currency fluctuations affect

the global economy. First, they may change a competitive position that can influence the changes

in cost structure compared with the global counterparts thus altering the market share. Secondly,

firms may require to re-visit strategic decisions like location of production centers, or entries into

different markets in light of exchange rate outlook because currency fluctuation presents a major

factor that influence investment returns. Long-term planning processes also need to take into

consideration the possibility of shifts in the overall economic environment due to fluctuations in

the exchange rate levels of different countries to assure that there are always viable mechanisms

for the adjustments of prices and sourcing to remain competitive in the global market.

### 4.2 Exchange Rate Forecasting

It is important to predict changes in exchange rates for any organization and an investor who

operates in the international market. Three primary approaches are used for this purpose:

Momentum indicators, fundamental analysis, and technical indicators are some of the methods

used in the determination of share prices in the market.

Fundamental Analysis

Technical analysis is based on the premise that historical price fluctuations dictate the

movements of present exchange rates while fundamental analysis revolves around the economic

factors attributing to the exchange rates. As predicted by some economic data release calendar

and macroeconomics fundamentals of the intended currencies.

Key Techniques

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Purchasing Power Parity (PPP) is that type of concept of exchange rate that insists that exchange

rates should be adjusted to make the prices of similar goods or services as compared to other

countries. Its useful in economistic approach used in comparing inflation rates and predicting

long-term changes in exchange rates. For instance, if a country earns a higher inflation rate than

the other and hence has lower purchasing power than the other; it is expected to let its currency

devalue to the average rate, thus depicting the change in the purchasing power. It is important in

the determination of capital flows and exchange rates around the world because of the way

interest rate differentials work. Higher interest rates can attract foreign investment which in turn

can lead to an appreciation of the currency relative to other currencies while low interest rates

can have an opposite resulting to depreciation of the currency. Interest rate movements and

trends in this regard are also closely tracked byChecking policies of the central banks for

predicting the movement of exchange rates, it is expected that differences in interest rates

influence capital flow as well as the worth of its currency. Therefore, economic indicators help in

evaluating; the strength of economies, and their related currencies. Other important analyses that

the analysts focus on include; Alteration in Gross Domestic Product, employment level, trade

balance, and fiscal policies among others. Better economic performance tends to lift up a

currency, while poor economic conditions could bring about a devaluation. Regarding these

criteria, analysts use them to provide an evaluation of economy performance of different

countries and to forecast movements of the currency realizing the impact of economic indicators

in relation to exchange rates.

Technical Analysis

Technical analysis refers to technical analysis based on past market data, more emphasis is

placed on price and volume to predict future exchange rate trend. It bases its action/inaction on

the fact that in technical trading, past trends and prices are indicators of future trends.

Key Techniques

Chart patterns refer to shapes that price charts offer including head and shoulder, double

tops/bottoms and triangles. These patterns are used by analysts to make strategic predictions on

future trends in price movements; the head and shoulders for instance are used to predict possible

downward reversal of an upward trend. Through such patterns, the analysts analyze and predict

market trends of changes in price direction through charting techniques. Moving Averages:

These are indicators of average prices used in detecting trends and reversals in currency markets.

Such averages include the simple moving average also referred to as SMA and the exponential

moving average also known as the EMA; these averages work by reducing noise levels on price

data in order to give investors insights into direction of the market. Traders pay special attention

to such indicators as short-term and long-term moving averages and when they cross each other a

buy or sell signal appears according to the position of the short-term MA in relation to the long-

term MA. Relative strength index (RSI) helps in establishing indicator of the current condition of

the particular currency, taken from its absolute rates of recent periods and gives information if it

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is overbought or oversold. Whenever the RSI rises above 70 levels, it may mean that a certain

currency is expensive and might be subject to a downward correction and conversely if the RSI

drops below 30 levels it will indicate that the currency is undervalued and may be due for an

upward reversion. Analyses can then determine when changes in the attitudes of the markets are

likely to occur based on the observed RSI levels in order to predict turning points in the

currencies.

Market-Based Approaches

Finally, in the case of market-based approaches, expectations used to predict exchange rates are

obtained from financial markets. Another key method of determining present value is the use of

today’s exchange rates anchored on the expectation of a given currency in relation to another

currency in the future.

Key Techniques

Forward Rates are the rates that are fixed today for use in the future and are calculated using the

formulas that involve the current spot rates and interest rate differentials. It is also good to note

that although forward rates can act as unbiased expectations of the future spot rate, its projection

is often skewed by market anomalies and events. They turn to forward rates when gauging future

currency movements, though they do so with several reservations owing to influential factors

influencing market conditions. Futures and Options Markets are also useful to evaluate Market’s

expectations for future exchange rates. Currency futures and option contracts deliver information

on price, namely price levels and volumes to enable the analysts to tag along market sentiment

and make reasonable forecasts of movement of currency. The carry forward and forward and

options markets can help foresee market expectations and forecast movement in exchange rates.

Market Sentiment Indicators like COT reports and Everyday/Weekly sentiment surveys give the

trader and investor insights of the position held and attitude taken. Using the mentioned

indicators, the trader has a good prediction of the toned market, whereby bullish or bearish acts

depict the direction of currency. Mainly, there are market sentiment indicators that analysts

combine with other tools for an analysis of market sentiment and forecasting of further

fluctuations of the exchange rate.

4.3 Currency Risk Mitigation

Reducing risks on currencies is very important for organizations that deal with export and import

or carry out international investments. Some of the main measures envisaged for risk

management include the provision of currency diversification, leading and lagging payments, as

well as centralized treasury operations.Foreign currency risk management entails the use of more

than one outside currency to reduce or offset a company’s risk exposure. This minimizes the

overall exposure of currency risk that can be associated with the fluctuations of a particular

currency.

Currency Diversification

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Revenue diversification is done by selling the products and services across the various

geographical locations where different currencies are used. Cost adaptation involve the use of

many currencies to both purchase inputs and incur costs in the same currency as sales revenue.

Also, by investment diversification it is meant that asset and cash holdings are made in different

currencies.

Benefits: It has also long been widely known that hedging against one currency with another

minimizes the potential shocks from any given currency. This strategy facilitates in reducing the

volatilities of both cash flows and the earnings due to changes in currency fluctuations, making it

easier to predict financial performance since gains and losses are balanced depending on the kind

of exposure to different currencies.

Challenges: Working at a firm which handles several currencies calls for a high level of financial

management due to the complexities that arise from this aspect. Moreover, with more currencies

in use, the cost and fees for every transaction also rise meaning that the possibility of undue

diversification could erode some of the monetary gains derivable from the exercise in the end.

Leading and Lagging Payments

Receivable and payable control is a measure that premits making and giving payments ahead of

time in order to benefit from such exchange rate movements or delaying them in order to avoid

such movements.

Implementations

Leading Payments: Depending on the nature of the expected currency fluctuation, making

advance payments means that a company can be able to obtain the currency at a lower cost in

relation to its domestic currency, thus minimizing on the total cost of foreign currency liability.

For example, if a firm in the United Sates anticipates that the euro was going to strengthen in the

future then it has to buy goods from Europe at the lower current exchange rate.

Lagging Payments: One major advantage of deferring payments is that a company can hedge

against exchange loss by timing the payments given the understanding that currency is expected

to depreciate in the future. For instance, if a U. S company is holding the view they will =$ when

engaging in foreign exchange that the yen would weaken then it has to delay its payments on

goods and services imported from Japan to get a better exchange rate.

Benefits: Among all factors of cash management, effective payment timing is acknowledged to

contribute much to cost reduction. The model also enables the possibility to apply more

adjustments to a new exchange rate climate, which helps in Strategic planning.

Challenges: One of the main problems of collecting such data is that it presupposes the consent

of the suppliers or customers which can hardly be always received. Also, it depends on

integration of currency fluctuations and these prove to be very unpredictable and hard to predict.

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Centralized Treasury Operations

Consolidated treasury management is a concept where all decision-making related to currency

management or risk is centrally coordinated through a head treasury department.

Implementation:

On the one hand, companywide approach to decision-making about foreign exchange risk

management at a particular company is efficient since it is compatible with a centralized

approach that allows for the coordination of the system at a particular company. On the other

hand, the centralized hedging programs, such as those using financial instruments such as

forwards, options, as well as swaps are also highly effective. Besides, if a subsidiary has cash in

multiple accounts, pooling the money into a master account makes it more easily accessible and

reduces the risks of fluctuating foreign exchange rates.

Benefits: The management of many resources on a large scale through centralization leads to the

reduction of costs and duplication of services in different subsidiaries. Again, since some

financial capital is centralized and specialized, there is improved management of risks within the

financial sector. Centralization similarly, helps in ensuring conformity to the principals of risk

management policies and strategies across the organization.

Challenges: Centralization and its overall management can often be challenging even if it is a

huge multinational company. The need to promote collaboration and integration between the

central treasury and several subsidiaries is necessitated by the need to ensure harmony and

conformity to global policies.

5. Financial Instruments for Hedging

5.1 Forwards and Futures

Both forward and futures are common tools whereby people can reduce exchange rate risk as it

allows sellers and buyers to agree on a certain rate in the future and thus protect themselves

against unfavourable movements in the currency.

Forward Contracts

Forward contracts are bilateral contracts between the two contracting parties with the objective

of purchasing or selling a specific quantity of currency at a usual rate on a certain future date.

Although these contracts are executed similarly to futures and options contracts, they are referred

to as over-the-counter (OTC) contracts because they are not standardized like futures and options

contracts, thus being more flexible in that their size, their expiration date, and the currencies

involved can be changed.

Characteristics: Forward contracts are flexible for the parties in sense of the contract execution as

all conditions are agreed in advance. They are direct bilateral contracts which mean that they are

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not traded on an exchange but instead between non residents such as banks or large corporations.

That is why forward contracts have fixed terms that cannot be adjusted once the parties agree to

the contract terms, which give a certain level of certainty of future cash inflows. However, the

situation poses risks to parties transacting with each other due to the credit risks that the

counterparties bring into any contractual arrangements in an effort to fulfill the obligations that

they have undertaken.

Applications: Forward contracts are also taken by companies to lock in or to buy foreign

exchange in advance at a fixed rate and reduce their transaction risks. That forward is also used

by investors for speculation on future currency price direction to make a profit on expected move

in exchange rates.

Future Contracts

Futures are short-term financial derivatives that state the obligation to purchase or sell at set

terms a fixed quantity of currency for a fixed price on a specific future date. Futures, on the other

hand, are traded on prevailing exchanges, including the CME, and contracts are more

standardized in terms of their size, expiration dates and how the final settlements are prepared.

Characteristics: Futures contracts provide contractual terms and are traded on exchange markets

which means they are standardized and readily available. They include daily cash flow

determination of profits and losses through the use of marking to market value, thus minimizing

counterparty credit risk. Initial margin and maintenance margin are guarantees that must be

provided by the parties to ensure the credit risk does not crystallize by providing cover for

potential loss. Further, futures contracts may also be closed out before their expiration which

gives even more leverages when it comes to the notion of hedging or speculating.

Applications: They hedge the foreign exchange risk involved in import/export and investment

related to international business by employing futures contracts, which provides cushion against

any unfavourable shift in currency value. There’s information transmission between the futures

and spot markets due to traders’ activities in seeking profit from the arbitrage opportunities

between them, hence improving the efficiency of the markets. Another reason investors use it is

for hedging purposes in that one is able to trade in the future markets to run profits in relation to

expected changes in currency prices.

5.2 Options and Swaps

Currency swaps are agreements under which two parties receive receivables expressed in one

currency in exchange for a fixed amount of another currency. They cover long durations and are

unique with provisions keyed to the terms wanted by the contracting parties.

Advantages: Currency options are very flexible since they allow persons or companies the right

but not the obligation and this is very crucial since businesses can take near risk-free gains when

exchange rates are in their favor while at the same time putting a cap on the amount of money

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they can lose if the rates are unfavorable. The risk minimized in the option is equal to the payout

or the premium for the option, which makes it even less risky than other hedge instruments.

More so, options provide the speculator avenues through which they can make more money in

anticipation of certain movements in the value of a currency without staking huge amounts of

capital. Disadvantages: However nonetheless, it bears the cost of a one time premium, which can

at time be very costly, especially if one is taking long term option or during periods of high

market instability. Some of the strategies related to options can be rather difficult to understand

and, in spite of this, it would be hard to implement them without having proper knowledge and

experience. In addition, while providing flexibility, it can also be seen that not all the options are

available with customized flexibility for all pairing of currencies or the desired contracts as well

thus making it importantly inapplicable for several businesses.

Currency swaps refer to arrangements whereby two parties get amount stated in terms of one

currency for a fixed sum of the other currency at a fixed rate. They take long durations and are

special with clauses that are designed to reflect the contractual provisions desired by the parties

involved.

Advantages: Currency options are quite flexible since they afford persons or companies the right

but not the obligation and this is very important since businesses can make near risk free profits

when exchange rate are in their favor, and at the same time control the amplifier of their losses if

exchange rates are against them. The risk being hedged in the option is as equal to the payout/ or

premium of the option that in fact make it even less risky than most other hedge instruments.

More so, options afford the speculator opportunity in which he/she can make more money in

anticipation of movements in the value of a certain currency without putting his/her large capital

at risk. Disadvantages: However nonetheless It carries with it a one time fee, and at times this fee

can be relatively steep, this may for instance be when one will be transacting in the long term

options or during volatile periods in the market. Some of the strategies regarding options can be

rather tricky to grasp let alone, if they have to use it for real. At the same time, as considered

earlier, while offering the flexibility, it can be also noted that not all the options are available

with customized flexibility for all the pairing of currencies or for the desired contracts as well,

which is, thus, making it importantly inapplicable to several businesses.

5.3 Choosing the Right Instrument

Several tools of hedging come with their strength and weakness while engaging in it, so the

company needs to conduct research to identify which strategy to use based on its objectives.

A consideration of relevance is the **Cost**. For instance, currency options entail paying for a

premium in anticipation of a specific currency option that may be expensive initially, depending

on the time horizon of the contract or when the volatility of the market is high as pointed out by

Hull (2018). This cost thus might be justified if the firm requires the flexibility options afford.

However, forward contract does not entail any upfront payments apart from the costs which are

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implicit in the forward rate whereby costs are preferred based on differential interest rates

between the two currencies being forward contracted (Madura, 2012).

The last functionality to address is **flexibility**, which is also an important one. Futures, on

the other hand, are individualistic and highly standardized in format; they involve contract right

but not the obligation to trade at a given price. This feature is particularly useful when FCFs that

are associated with an investment are not known in the future, since it enables the firm to hedge

foreign exchange risk and benefit from favourable movements in the exchange rate while

managing the risk of unfavourable movements (Black & Scholes, 1973). Forward contracts, on

the other hand, can be rigid since they bind the firm to a specific transaction at a specific rate

based on the current market affiliations regardless of the market’s future fluctuations, a

disadvantage that may hinder the firm more so when realizing its cash flow requirements in

future.

The **risk of the operation** that the firm is into is also another factor that determines the

courses it must chart out in its business strategies. Those firms with minimal risk appetite might

opt to forward contracts in that they will settle for definite exchange prices and effectively

exclude any risk in currency altogether (Shapiro, 2013). On the other hand, those companies

ready to take risks in expectation of gains might prefer options that while costing thus limiting

the loss to the price of the option give the firm an opportunity to gain as much as the exchange

rate improves, if protected by Bodnar et al. , 1998).

One should also take into account **market liquidity **and state of the **market**. For

example, futures contracts; futures contracts provide high market liquidity and are designed

under standardized forms and often used by the firms which are required to hedge within the

liquid and transparent financial markets as pointed by Hull (2018). Thus while cash flow hedges

are best suited for the tactical and short-term management of exchange rate risks, swaps due to

their flexibility and possibly complexity are more suitable for the strategic role that involves

long-term hedging of cash flows and strategic cash flow matching (Eiteman et al. , 2019). Thus,

the choice of the right hedging instrument can be made based on the assessment of the cost and

flexibility of the hedging instrument more appropriate to the firm, liquidity and market state of

conditions. It is, therefore, important for firms to assess various factors to be able to select the

appropriate instrument that will meet its financial strategy as well as its risk management plans.

6. Integrative Risk Management Approaches

6.1 Comprehensive Risk Assessment

Market Risk which includes the dangers of losing money through stock investments, Credit Risk

which involves companies’ ability to manage their loans, a firm’s Liquidity Risk, and

Operational Risk or managing risks that threaten the very existence of a business (Jorion, 2007).

Market risk is the uncertainty in the market and it encompasses the interest rates risk, foreign

exchange risk, and commodity price risk. Under the circumstance, timely valuation can assist

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firms to minimize an exposing position that may lead to losses due to fluctuation that can affect

profit or boost cost (Hull, 2018). Credit risk entails an actual default by the counterparty in

failing to meet contractual commitments. A clear identification of exposure to credit risk

facilitates the adoption of credit risk management measures that may include setting up of credit

limits as well as demand for collateral and diversification in counterparties (Madura, 2012).

Liquidity risk category relates to the firm’s capacity to manage short-term commitments and

minimize larger losses. Generally, an effective risk appraisal analyzes and considers three

perspectives; the current cash flow, the current positions of liquid assets, and accessibility to

capital markets in order to assess the capability of the firm in meeting its commitments in

different circumstances such as under financial pressures (Brealey & Meyers, 2017). According

to Pollard, operational risk encompass risks that originate from various internal and external

factors such as internal structure of the bank, people who work in the bank and external

circumstances among others. Evaluating these risks entails reviewing internal control

mechanisms, compliance measures, and contingencies when control and other breaks may occur

(BCBS, 2006). Global risk analysis includes ten-torial risks, which relate to the firm’s major

goals and objectives, including changes in the competitive environment, legal requirements, and

technological shifts over time. Koontz & Weihrich (1981) stated that through doing so, firms can

work towards achieving the objectives of competitiveness and compliance while applying

Porter’s framework (1980).

6.2 Coordinated Risk Mitigation

Managing risks means not only addressing them individually, but selectively – or coordinating

them in case they belong to various types. Thus, firms have an enhanced security against market

risk as well as against credit risk, liquidity, operational, and strategic risks through the adoption

of the management strategies of; credit, market, liquidity, operational and strategic risks. Here’s

how to coordinate these efforts: Here’s how to coordinate these efforts:

Establish a Centralized Risk Management Framework

Risk Governance Structure: Risk management organizational structure is the establishment of a

centre of gravity for risk management that consists of risk management committee that

comprises personnel from many departments like finance, operation and compliance to oversee

risk management activities. Similarly, there is a need to nominate a Chief Risk Officer (CRO) to

oversee the smooth running of risk management policies with the intention of harmonizing its

standards throughout the entire network (Lam, 2003). Integrated Risk Management Policy: The

risk management policy should be well developed in order to capture the risks that need to be

managed. The internal policy should explain how the firm is willing to take risks and how much

risk appetite it has for a given risk type; ways to manage such risks. It is critical that this singular

policy implemented, that should be clearly understood and applied across the organization by all

departments in order for risks to be managed consistently and cohesively (COSO, 2004).

Comprehensive Risk Identification and Assessment

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Risk Mapping: Assess all potential risk types to allocate them into market risk, credit risk,

liquidity risk, operational risk, and strategic risk. Mention practices such as assessment

approaches, for example, scenario analysis and stress testing, to determine the possible effects of

each risk (Jorion, 2007).

Unified Risk Mitigation Strategies

Market and Credit Risk Mitigation: To address the problem of risk on the financial markets it is

suggested to use derivatives of different types such as forwards and futures, options, and swaps.

For credit risk, utilize credit facilities such as credit derivatives and set credits ceilings for

counterparties (Madura, 2012). For instance, it is essential to invest in different markets or sell

products to different buyers to avoid being affected by the market or buyer’s failure.

Liquidity and Operational Risk Mitigation: It is important for a cashier to have enough liquidity

to meet the required amount of cash flow under various circumstances, as well as to set up credit

lines. Several methods should be employed in managing liquidity risk in order to budget for the

expected or required cash inflows and outflows in the business (Brigham and Ehrhardt, 2017).

Have sound corporate governance and measures of internal control and compliance with

regulatory standards with the aim of addressing operational risks as they occur and modifying

procedures in order to keep up to date with emerging risks (Basel Committee on Banking

Supervision, 2006). Strategic Risk Mitigation: To effectively manage the business, one needs to

undertake scenario analysis in order to determine how the changes in the competitors’ strategies

and the institutional environment will affect the company’s operations and then purposely create

strategies to address these changes (Porter, 1980). We have an organizational function of acquire

or develop appropriate technology and keep abreast the top trend thus eliminate risk of becoming

obsolete or a lesser competitor.

Continuous Monitoring and Reporting

Risk Dashboard: The best practice in working on the risk dashboard is to establish the most

important risk indicators to be monitored regularly across all types of risks and make reporting

real time. This dashboard should be available and shared with decision-makers and appropriate

individuals involved so that when there is an emergence of an issue, quick action can be taken to

address it (COSO, 2004). Regular Audits and Reviews: Periodically evaluate the status and

perform control and risk analysis to determine the efficiency of organizational risk management

tools and adjust the measures, if needed. Make sure that the audit findings are reported to the

central risk committee and that they are embodied in the company’s risk management (Basel

Committee on Banking Supervision, 2006).

6.3 Risk Management Policies and Procedures

Risk management policies and procedures refer to pre-established guidelines that can be used in

managing risk hence they are very essential in a process of maintaining the quality and efficiency

of risk management in an organization.

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1. Risk Identification and Assessment

Risk Identification: Decide on the risks to be assessed, as market risks, credit risk, liquidity risks,

operational risks, and strategic risks, and make a risk map to provide a clear picture of all

potential risks. Risk identification techniques may include risk matrices, SWOT, and other

planning tools with the aim of mapping out all risks that can occur (Jorion, 2007). Consult

various employees from other departments of the organization as it will help to obtain various

perceptions regarding potential risks and their consequences (COSO, 2004). Risk Assessment:

Classify each of the identified risks according to the likelihood and the impact that each of them

poses qualitatively, and then quantitatively, to establish an accurate priority (Lam, 2003). Also,

engage in risk mapping that involves an analysis of how various risks are interconnected and

impact each other in order to have an improved comprehension of the general risk paradigm and

subsequently eradicate or at least, minimize the impacts of the many risks (Hull, 2018).

2. Policy Formulation

Establish Risk Management Objectives: Make sure that all the risk management objectives are

stated in line with the strategic goals of the firm and levels of tolerance to risks (COSO, 2004).

Have defined personnel risk tolerance levels that should be used in the risk management

decision-making process and in the risk activities of the organization. Develop Risk Management

Policies: Develop a clear risk management policy which is based on a conceptual framework for

risk management, RM roles and responsibilities, approaches to risk evaluation and reporting

lines (BCBS, 2006). Seek endorsement from top management and board of directors to gain

commitment and support for the risk management policies as a key reinforcement needed in the

organization.

3. Procedure Development

Detailed Risk Procedures: Policies that state how to approach the assessment and management of

risks as well as how to monitor the effectiveness of the measures that were implemented

(Madura, 2012). The presentation of these SOPs should identify further the roles and

responsibilities of individual and organizational entities regarding risk management to enhance

accountability and tend to proper implementation. Integration with Business Processes: To make

use of risk management procedures with no arbitrary application, it is necessary to incorporate

risk management procedures into business operations (Brigham and Ehrhardt, p. 15). Where it is

possible, use checklists, workflows, and mechanical interfaces in order to simplify all the work

affected by risk management and make it more efficient. Organisational members are able to

incorporate risk management practices into the process of their work and are made aware that

they are not discreet activities.

4. Training and Communication

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Risk Management Training: It is recommended to instill an educational training model that aims

at making the employees effectively understand the organization’s risk management norms and

policies, and the role they play in overall risk management process (Lam, 2003). Promote

improvements in personal and organisation/enterprise risk management knowledge and

competency by supporting regular education programs such as workshops, seminars, certification

processes for the employees. Effective Communication: These include cascading risk

management policies to subordinates, work in teams, reporting on risk management activities

and findings, as well as regularly updating the various stakeholders about risk management

activities and findings (COSO, 2004). Risk management performance should be communicated

periodically by reports and periodic meetings they should enhance organizational culture to

embrace changes in Risk Management Performance and Emerging Risks.

5. Monitoring and Improvement

Continuous Monitoring: General: Incorporate specific metrics to monitor risk indicators,

effectively alerting when problems may arise (Hull, 2018). Furthermore, one ought to conduct

assessments of risk management measures on a routine basis in order to evaluate their efficiency

and compliance with directives in terms of avoiding risks actively (Basel Committee on Banking

Supervision, 2006). Feedback and Improvement: Apply ways and means of soliciting opinions

and feedback from various employees and stakeholders as well as from generals that would help

in recognizing areas that need improvement and can be applied in risk management functions

and controls.

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