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FINANCIAL HEDGING OF ECONOMIC EXPOSURE WITH DERIVATIVES
1.0 Understanding Economic Exposure and Its Impact
1.1 Definition and Sources of Economic Exposure
From Bodnar & Wong (2019) it can be understood that economic exposure is understood to be the
exposure that a firm has towards exchange rates, the cost of importing and exporting, other
macroeconomic factors affecting the price of the firm’s goods and services as well as interest rates hence
how the firm is vulnerable to shocks. It is not a one-off impact of exchange rate changes on these specific
transactions, but impacts the general macro-economic setting within which the operations of the firm take
place (BT,2013)Economic risks are another category, which refers to possibilities that may be initiated by
changes in customer behavior and legislations, international conflicts, and technological innovations,
among others (Li, Weber & Suter, 2017). These aspects of competition can be formidable enough to wield
major impacts on a firm’s operational activities, its supply chain ties and cooperation with its strategic
partners, and on its overall competitiveness and positioning in targeted markets. The case of economic
exposure goes beyond the processing level and reaches downstream consequences within interrelated
economies or sectors (Bakshi & Cao, 2017). This has expounded because any change that occurs in one
component part of the macroenvironment has a domino effect on the other and hence is likely to
significantly affect the firm’s cash flows and competitivity. Hence, functional management of economic
exposure rises its importance at the firms’ level and to accomplish this, several efficient techniques are
used such as scenario analysis, sensitivity analysis and dynamic hedging to assess and manage the risks
and opportunities emanating from such exposure effectively (Bodnar & Wong, 2019). Macroeconomic
environment can thus be defined as the large scale economic factors that have an impact on firms’
operations and performance under the current business risk environment; this is because by managing the
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factors actively, more organizations are able to overcome the risks in order to attain sustainable long term
stability for firm competitiveness in the market.
1.2 Effects on Firm Value and Profitability
As defined by Bodnar & Wong (2019), Economic exposure is the reverse of static vulnerability and refers to
the different ways through which exchange rate movements and other macroeconomic variables affect the
value and profitability of a firm. Interestingly, economic exposure unfolds through different conduits other
than the direct effect on individual transactions, each with its unique consequences on the profit
consequences and competitive advantage of a firm (Adler & Dumas, 2015). For instance, the increase in
value of the home currency assists the firm to buy more imports using less money; however, it hampers the
ability of the firm to sell its exports in foreign markets due to high prices that consumers are willing to pay
for them (Campbell & Kracaw, 2017). On the other hand, devaluation of the home currency might improve
export competiveness but at the same time escalate the import cost of materials thereby sensitive profits
(Chen & Li, 2019). More flows in the exchange rate may translate to higher costs of raw materials and
intermediate good (Bakshi & Cao, 2017). This holds importance for production costs given some firms’
dependence on imported inputs, or given industries that may operate in low margin for profit environments.
Economic exposure also goes beyond the operational context right up to the risk and more specifically the
future cash flows affecting investors’ perception and subsequently the firm’s cost of capital and the value
(Bodnar & Wong, 2019). Risk may also be exacerbated in phases of financial unrest or fluctuating currency
risks that might mean that investors require higher rates of return, thus increasing the firm’s cost of capital,
and hence the decline in valuation multiples (Chen & Li, 2019). In addition, the impact of economic
exposure on the value and performance of organization is modulated by several factors such as industry,
market position and risk management practices. Henderson and Power (1994) also articulate that
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industries with high dependence on imports or direct net expose to foreign markets may be affected more
by exchange rate changes by Campbel et al, (2017).
1.3 Measuring and Quantifying Economic Exposure
Evaluating and quantifying economic exposure as a risk measure is one of the agenda of firms today to
manage their risks involved in their globalization strategies (Chen & Li, 2019). By doing so, it helps the
company to know to what an extent its financial performance and strategic plans are sensitive to changes
in macroeconomic factors such as fluctuations of exchange rates, interest rates and changes in prices of
commodities among others (Bodnar & Wong, 2019). In analyzing economic exposure, one can use a
simple regression analysis where the interrelation between macroeconomic variables and the firm’s cash
flows or stock prices is checked to anticipate the effects they may cause (Bodnar & Wong, 2019). This
approach enables the firms to estimate how some figures related to the company’s financial performance
will respond to changes in the economic factors of concern thus identifies the opportunities for increasing
the value for the firm (Campbell & Kracaw, 2017). Another uptake is the cash flow sensitivity analysis
where by adjustment of the fluctuations in the macroeconomic factors and the resulting variation expected
in the flow of cash (Chen & Li, 2019). This means that through presenting different situations and
subsequently evaluating the relation between exposures and cash flows, firms will be in a better position to
determine the quantum of condition and direction belonging to macroeconomic risks (Bakshi & Cao, 2017).
It makes use of scenario analysis in order to determine the impact of selected macroeconomic events or
shocks in the overarching financial performance of the firm. This way, companies can prepare for the worst
and be ready to seize the best by coming up with strategic possibilities that counter changes in the
organization environment (Bodnar and Wong, 2019, p6). Also, the application of measurement in economic
exposure assists in determining the viability of various existing risk management practices to assess the
gaps that can be taken to enhance the practices (Bakshi & Cao, 2017). The actual exposure level is
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gauged and compared with the theoretical exposure level produced by these models, helping the
companies to fine-tune their hedging policies as they align the risk-management frameworks to their
strategic goals (Campbell & Kracaw, 2017).
1.4 Importance of Hedging Economic Exposure
Mitigating economic exposure is one of the critical objectives of risk management practices in the current
globe more so for the firms in the global markets (Bakshi & Cao, 2017). This practice involves the use of
financial derivative tools Forwards options Swaps and Natural hedge strategies to buffer the effects of
changes in macroeconomic variables on the cash flows and value of a company (Bakshi & Cao, 2017).
Forwards are financial contracts which enable organizations to hedge future business transactions on
specific currency exchange rates thereby affording them cover against fluctuating exchange rates in the
future (Chen & Li, 2019). Options give a chance to either option to purchase or sell the currencies within the
specific given prices, enabling the downside protection while enjoying the positive move of the specific
currencies (Bodnar and Wong, 2019). Swaps can thus help organisations engage in cash flow or asset
transactions which are expressed in two different currencies effectively minimizing on currency risk (Chen &
Li, 2019). Furthermore, the hedging techniques include managing business transactions and investments in
ways that minimize inherent currency exposures within the firm’s operations (Bodnar & Wong, 2019). Since
full micromanagement of the economic exposure is impossible, the hedge initiatives focus on reducing cash
flow variability and buffering the profit against adverse macro-economic influences (Chen & Li, 2019). Risk
management should always be done by carefully developing complex hedging policies that perfectly suit
the firm’s risk tolerance levels, overall corporate goals, and current market conditions as recommended buy
Bodnar and Wong (2019). Through managing economic risks, companies can enhance their structural
stability and long-run growth prospects in the face of diverse global risk volatilities (Campbell & Kracaw,
2017). This kind of hedging is not only protection but also a strengthening of buffers for stakeholders who
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will in turn have a stronger confidence to the firm’s security position in the market and which gives the firm
a solid fundamentals to maneuver around the volatile economic environment with relative easier measures.
2.0 Overview of Derivative Instruments for Hedging
2.1 Forwards, Futures, and Forward Rate Agreements
Deviations such as forwards and futures, and forward rate agreements (FRAs) lie at the core of financial
risk management equipment employed by the market participants to protect against currency risk in world’s
financial markets (Dufour & Solnik, 2018). These derivatives have a number of product structures by which
they help investors to minimize risks and possible losses due to currency volatility. Over the forwards, for
contract flexibility, forwards are more flexible in terms of civil law as it provides an option to construct the
contract relative to the needs of the parties and enforceability of particular risks. This is mainly because
they are usually OTC, meaning that counterparties to the trade are able to negotiate directly and access
customized solutions tailored to their risk profile and hedging needs (secular Dufour & Solnik, 2018).
Futures contracts, being the standardized agreements that are traded on the organized exchanges, can
offer the scope of risk hedging to the market players in a fairly accessible manner (Dufour & Solnik, 2018,
p. 82). Futures contracts reduce transactions costs and hence increase the liquidity and efficiency of a
contract as it can easily be traded on large markets since it carries a market price as well as being easily
reportable and alterable by traders of all sizes (Dufour & Solnik, 2018). Further, other related hedging tools
like forward rate agreements (FRAs), which are quite similar to forwards but mainly used to hedge short-
term interest rate risks, provide hedge players even more product differentiation and accuracy in the
operation of risk management plans and strategies (Dufour & Solnik, 2018). FRAs provide a way in which
parties are able to fix the future interest rates thereby insulating themselves against future volatility of short
term rates and consequent effect on cash flows (Dufour & Solnik, 2018). By using these financial
instruments, various people in the market are able to protect themselves against any unfavourable shifts in
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currency values, thus protecting their financial investments, and at the same time, improving their
capabilities in addressing challenges in the new realm of foreign exchange transactions (Dominguez &
Tesar). This constructs a risk avertive and protective conduct that doesn’t only prepares and safeguards
against possible losses but also helps in maintaining market steadiness and stability during the highly
unstable and volatile economic world which in turn assist in the maintenance of financial stability and
sustainability.
2.2 Currency Options and Option Strategies
Currency options are considered an essential tool for mitigating risks within the foreign exchange market
due to the fact that it allows the participants to exercise control over their risks at variable rates of currency,
with even greater accuracy and efficiency (Dumas & Kharoubi-Rakotomalala, 2017). These financial
products are actually options, which provide the buyer of the option with a right but not an obligation to
purchase or sell a certain quantity of currency at a specific price in a specific time period usually referred to
as the expiry date (Dumas & Kharoubi-Rakotomalala, 2017). For example, an investor may use a straddle,
strangle, or collar to gain customized precise exposure to the risk-return possibilities of a given outlook for
changes in the currency price (Dufour & Solnik, 2018). For example, a firm expectantly facing high
fluctuation of currency value will employ long straddle options to enable it benefit most by changes in either
direction of the price with regards to its contract so as to maximize its profits. Currency options provide the
clients with great flexibility and capacity for managing risks relating to currencies, and can be effectively
used for hedging a particular risk or when speculating on the future changes in the currency value (Dufour
& Solnik, 2018). The currency options can, therefore, be said to act as insurance instruments that can be
used strategically by firms to hedge adverse currency movements and strengthen their balance sheets and
cash flows in the face of unpredictable markets and turbulent economic environment (Choi & Prasad,
2017). Furthermore, currency options enhance the control of risk by opening up a way through which
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investors are able to adopt fixed individual country currency risks profiles and business objectives in a
world economy, making the control of currency risks more personified and efficient (Dufour & Solnik, 2018).
These key features of currency options further enhance the general strength and efficiency of risk
management, and the flexible approaches they provide help the market stakeholders to operate in currency
markets with better insight and forecasts.
2.3 Swaps and Cross-Currency Interest Rate Swaps
Interest rate swaps, and cross – currency interest rate swaps (CCIRS) are prime products in the derivative
market and provide hedge mechanisms for changing interest rates and currency exposure (Dufour and
Solnik, 2018). Interest rate swaps refer to contractual agreements that involve swapping of fixed and
floating interest rates in the same currency this h/axes the flexibility of parties who want to alter their
positions in interest rates (Dufour & Solnik, 2018). , Cross-currency swaps allow entities to convert fixed
rate cash flow of one currency into floating rate cash flow of another and in this way, help to manage
currency risk while arranging its financing (Dufour & Solnik, 2018). Hence, Robucks argues that CCIRS
remain especially useful in cases when the underlying currencies are the strategic foreign currencies for the
multinationals involved in the cross-border operations since this product entails opportunity to hedge both
the currency and interest rate risks related to the global business (Dumas & Kharoubi-Rakotomalala, 2017).
With the use of swaps, market individuals are able to manage risk in the most appropriate and suitable
manner relative to their risk appetite and hence the risks involved in markets can be effectively managed
(Dominguez & Tesar, 2019). For instance, swaps allow companies to hedge their financings with the he
aim of matching their cash flows to eliminate the effect of currency risk on their results (Dumas & Kharoubi-
Rakotomalala, 2017). Furthermore, swaps help trade finance its members in improving the financing
frameworks, that is through the financing in other currencies and interest rate environments and thus
cutting the overall cost of borrowing and thereby improving capital utilization (Dufour & Solnik, 2018).
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Furthermore, swaps are useful for managing risk in balance sheet positions specifically for the financial
institutions since it also facilitates the aspect of asset and liability management. Through swaps, the time
and interest rate risks of portfolios can be effectively managed since the banks can better manage
matching of the assets and liabilities which would lead to more financial stability. (Dufour & Solnik, 2018).
2.4 Exotic Derivatives and Structured Products
As Choi (2010) & Prasad noted exotic derivatives and structured products can offer sophisticated and tailor
made solutions for managing the currency risk, for the investor who has certain needs and perspective on
the market. Other examples of exotic derivatives include the barrier options, Asian options, and digital
options which are characterized by more features and flexible options of the payoff structure which offers
investors a way of hedging certain risks in the markets or capturing specific and special opportunities in the
markets (Dumas & Kharoubi-Rakotomalala, 2017). These options prevent or allow the holder to buy or sell
based on specific price levels, thus providing well-defined risk protection. More acceptable Asian options
that rely on averaging the price during a given time rather than the spot price at the time of expiration
reduces these fluctuations greatly. As with fixed income sells, digital options guarantee fixed revenues in
case pre-defined parameters of the underlying assets are met, and are suitable for certain risk
management situations (Choi and Prasad 2017). Some of the promotional structures are categorized as
structured products such as the currency-linked notes and the dual currency deposits which combine the
derivatives with the traditional financial instruments to provide different levels of risk and reward to the
investors as identified by Choi and Prasad (2017). Currency-linked notes offer returns in accordance with
currency values, containing elements of fixed income securities and options on currencies, to moderate
currency risks as well as potentially increasing returns. The carry trade attracts higher interest rates
whereby the depositor agrees to be paid in a different currency than the currency they lodged at the bank
through the expectations of exchange rate changes (Dufour and Solnik, 2018). These products aim to allow
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investors to gain direct access to currency markets as well as prepare for volatile times, and they present
unique ideas and strategies to achieving this. Nonetheless, exotic derivatives or the structured products
distinguished from standard derivatives have usually higher associated complexity, costs, and risks
(Dominguez & Tesar, 2019). These structures are complex, and as such, their management needs
expertise thus making challenges for the newcomers in the investment arena. Despite the fact that these
instruments provide customized hedging of the currency risk and the way to improve the future returns, the
use of these instruments requires the deep attention and specific knowledge to manage these derivatives
without use extra risk (Dumas & Kharoubi-Rakotomalala, 2017).
3.0 Designing Hedging Strategies with Derivatives
3.1 Identifying Exposure Sources and Hedging Objectives
A number of studies have identified that evaluating exposure sources and its hedging objectives form the
foundation for an ideal risky management plan (Eichengreen & Hausmann, 2020). Companies need to
understand the basics of the various kinds of exposure that firms are exposed to that include transaction
exposure, translation exposure, and economic exposure that may be occasioned by international business,
foreign investment and competition. Exchange risk, also called transaction exposure, is the risk resulting
due to changes in the exchange rate and its impact on the value of cash transactions made in the future in
terms of another currency. Accounting exposure, also known as translation exposure, is a measure of
currency risk that looks at how fluctuations in exchange rates affect a company’s financial statements when
they are consolidating financial statements of their foreign subsidiaries. Economic exposure involves
potential exchange rate changes on a firm’s overall value that affects its market position, strategic approach
to pricing their goods, and future revenue streams (Goldberg & Tille, 2018). The primary function of
hedging is to reduce the impact of these exposures on firm’s cash flows, earnings and value. (Goldberg et
al. , 2018). It will be useful to integrate goals and objectives of hedging with the overall financial
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management goals and the tolerance for its risks to enhance the efficiency of the risk management plan
developed by Fernandes et al. (2018). For example, a firm might target to balance cash flows for usage in
operation budgets, preserve profits to meet contractual obligations, or obtain a favorable market position in
global markets (Gabaix & Maggiori, 2019). While stabilizing cash flows can be important in ensuring that
proper liquidity is maintained this can also be important in ensuring that proper functioning or operation is
sustained. Likewise protecting earnings can be important in meeting the various expectations that investors
or parties to various financial agreements have placed. These objectives should be in line with the general
strategy of firms but must also bear in mind the unique sector, milieu, and strategic goals. For instance, an
organisation with significant international trading with foreign nations may consider hedging to reduce
impacts of negative movements in the currency structure, which may reduce profit margins. Likewise, a firm
with most of its debt in a foreign currency might use hedging to tackle fluctuations in exchange rates when
it comes to serving the financial accommodation’s interest and principal expense (Eichengreen &
Hausmann, 2020). In creating an optimal structure for ORM, exposure sources are determined and
established to identify risk objectives, with the subsequent design and risk management development
process reflecting organisational goals and financial strategies (Fernandes et al. , 2018).
3.2 Selecting Appropriate Derivative Instruments
The process of identifying and choosing proper derivatives begins with the definition of a firm’s exposures
and hedging aims (Class, 2010). Some of the well-known and often-used financial derivatives are forwards,
futures, options, and swaps, all of which possess unique benefits as well as costs to users (Fernandes et
al. , 2018). For instance, forwards and futures can ensure the exchange rates, which can guarantee that
the future cash flows need to boost the firm, especially if a firm enjoys a fixed schedule of payments.
Among these instruments, it is vital in hedging transaction exposure through future cash flows usually
required to be in a foreign currency (Goldberg & Tille, 2018). Option on the other hand are flexible because
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they give opportunity to make profit from favorable rates change and at the same time being secure when
the rates turn negative. This makes options ideal for firms that would wish to hedge against change in the
exchange rates but at the same time seek to draw on possible gains from such change in future. For
instance, a firm facing currency risk may decide to engage in option use for hedging purposes in order to
minimize susceptibility to fluctuations in the currency in the wrong direction while at the same time still be in
a position to take advange of favorable fluctuation in the currency to their gains (Fernandes et al. , 2018).
Exhibit B Interest Rate and Cross Currency Swaps Swaps especially, interest rate and cross-currency ones
are useful for managing long-term exposure and ensure that sources and uses of funds are in appropriate
currencies. Interest rates swaps involve the links of a fixed interest rate and a floating-rate interest, this is a
useful way of minimizing the interest rate risk. Cross-currency swaps can be used to fix the exchange rate
for the actual conversion of currency but it is more useful in the case when a firm pays and receives interest
in the different currencies; this is particularly helpful for large international companies with extensive
operations and financing requirements in different countries. The type of instrument that needs to be
employed depends on factors such as the type and the time period of exposure, feasibility with reference to
the costs involved, and proficiency of the management in managing sophisticated financial instruments. For
example, firms that lack knowledge of derivatives would go for basic products like forwards and futures,
whereas firms with a strong framework for handling risks in the financial market would employ a mix of
options and swaps in order to come up with hedging strategies that suit their precise needs.
3.3 Determining Optimal Hedge Ratios and Horizon
A hedge ratio represents the sensitivity of the hedging instrument to the change in the underlying asset
price and hedge horizon refers to the time period for which hedging is planned (Gampfer, 2016). The hedge
ratio, which specifies how much of the exposure should be hedged, should be defined in line with the firm’s
appetite for risk, other costs and the correlation coefficient between the exposure and hedging instrument.
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Estimation of the hedge ratio usually involves tools like regression analysis and innovative measures like
value-at-risk (VaR) models (Goldberg & Tille, 2018). Regression analysis comes in handy in estimating how
the firm may be affected by changes in market variables, whereas VaR models can be used to determine
the extent of losses that can be expected from a specific market position, and thus setting a hedge ratio
within the permissible level of risk (Froot & Stein, 2018). Another important factor pertains to the hedging
horizon, which refers to the time frame within which the hedge is kept in place, such as one year or longer;
this ought to coincide with the general operations planning cycle or the company’s financial reporting
periods. For instance, a firm with long-term foreign currency denominated debt may require a hedging
horizon that goes up to few years from now, whereas the hedging involved in an exposure against a
specific transaction may just require horizon of few months or weeks at most (Fernandes et al. , 2018). This
is a key consideration in business cycles because the timing of hedging horizons will then coincide with
periods of exposure ensuring that the hedge remains optimally suitable and effective for the entire period.
This therefore calls for embracing of regular hedge ratio and horizon review in order to address the
dynamic process and modify exposure at the firm. Hedging mechanisms can also fail because market
conditions may change over time as a result of economic factors, change in attitude towards risk, or
because of geopolitical factors and therefore it is imperative to develop more robust hedging tools (Gabaix
& Maggiori, 2019). Regular evaluation and modification of the hedging policies guarantee that the hedging
policies are consistent with the current risk landscape and the firm’s finances.
3.4 Implementing and Monitoring Hedging Programs
Steps in hedging entails putting in place the hedging strategy and the act of assessing the effectiveness of
the hedging policy on the risk management goals of the firm (Eichengreen & Hausmann, 2020). The roll out
of the hedging strategies must be coupled with strong internal controls, adequate communication
mechanisms, and proper records to monitor and document the hedging activities and other compliance
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matters (Fernandes et al. , 2018). There should be internal controls to avoid or check on the likelihood of
errors and to enforce compliance with the hedging policy and procedures, while proper and appropriate
communication channels should be in place to allow the sharing of updated information and coordination
among the stakeholders. Another advantage of the specific documentation is that it enhances the levels of
transparency and accountability as far as hedging activities are concerned since they can be audited easily.
This comprises of occasionally comparing the performance of the hedges, evaluating the market
conditions, and fine-tuning the strategy if required (Froot & Stein, 2018). Some of these aspects that have
to be monitored include the fluctuations in cash flows after hedging, the actual to expected outcome and
cost of hedging in the hedge instruments used (Goldberg & Tille, 2018). Reducing cash flow risk
contributes to the stabilizing the firm’s financial performance other; by aligning the hedges to projected
outcomes balance sheet hedge therefore demonstrates effectiveness in risk mitigation. Analysis of hedging
instruments in order to achieve maximum effectiveness in terms of costs and minimization of risks must be
an essential step in managing any company. Adaptive hedging is a relevant concept since firms learn
gradually new strategies, and new conditions in the market emerge or change (Gabaix & Maggiori, 2019).
Regardless of the hedging techniques employed, it is crucial to constantly remain abreast with the
prevailing financial instruments, change in regulations for hedging or changes in the market trends for the
purpose of enhancing the hedging strategy. Organizations should also conduct a review on period basis of
the risk management framework used in an organization to integrate insights and experience. Firms can
increase their capability to prevent or mitigate possible risks, become financially sound and sustain the
companies’ development. Adjusting hedging on frequent times assists in preventing its inefficiency in risky
market changes since the markets are not static (Eichengreen & Hausmann, 2020).
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4.0 Challenges in Hedging Economic Exposure
4.1 Basis Risk and Imperfect Hedging
Thus, basis risk and imperfect hedging remain as the main challenges for the firms that are attempting to
manage the currency volatility appropriately (Sarno et al. , 2018). This risk occurs when there is a mismatch
between the hedge instrument and exposure to the volatile changes in the underlying asset’s value, leaving
the hedger exposed to some risks (Portes & Rey, 2020). The following are some sources of basis risk:
mismatch between the hedge instrument and exposure on either the correct correlation between them, time
or maturity, modification of the market relationship between the exposure and hedge (Rajan &
Subramanian, 2019). Ineffective hedging takes place when the hedge chosen does not fully safeguard
against currency changes and the condition exposed submits the firm to slippery exchange rate volatilities
(Schoenle & Taylor, 2017). Reducing basis risk needs attention toward both the design of the hedging
instruments for reducing basis risk as well as the nature of the exposure to be hedged (Lucca & Trebbi,
2019). One pro is the dynamic adjustment of hedge ratios where firms can alter their hedging requirements
due to fluctuating market conditions and risks (Coudert & Gex, 2019). The hedging plan also needs to be
continually reviewed, including on at least an annual basis, to confirm that it remains fit for purpose (Bali &
Yin, 2020). Further, due to basis risk, firms can seek to minimize this risk through other methods like
preventing exposure to certain currencies or using more complex derivatives tools, Lustig and Verdelhan
(2017). Moreover, using ‘‘forward contracts or options with longer tenors is another way to decrease basis
risk because it makes the hedge time-frame match the firm’s exposure better (Chernenko & Faulkender. In
today’s uncertain global environment, while basis risk and imperfect hedging practices are some of the
factors that pose a risk to firms, sound written operational risk management practices will minimize on the
effects and protect against adverse movements in currencies.
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4.2 Liquidity and Market Access Constraints
Liquidity and the availability of products at the correct price pose certain impediments to the efficient
hedging of risks, especially in the case of entities that work in less liquid or restricted environments (Stock
& Watson, 2019). In such environments, derivative markets may have low richness and trading volume,
meaning that there is a potential for bid-ask spreads to widen, cost to be high and perhaps, executing large
hedging positions is difficult (Portes & Rey, 2020). This can be especially problematic during periods of
market stress or high volatility as seen everywhere during the financial crisis: liquidity evaporates and it
becomes much harder to hedge (Schoenle and Taylor, 2017). In addition, the political decrees or
constraints put in place by the local authorities may result in a limiting factor on the extent to which firms
are able to access particular derivative products or counterparty exposures, thereby complicating risk
management initiatives even further (Sarno et al. , 2018). To address these challenges, firms use strategic
practices like creating unique derivative contracts to fit the nature of their risks or entering into ‘’structured’-
risk management and hedging with financial institutions (Rajan & Subramanian, 2019). Likewise, firms
might consider beyond derivatives by relying on forward contracts or natural hedge as other risk
management techniques to avoid the effect of changes in foreign exchange rates (Stock & Watson, 2019).
As a final approach, P and L management, increased use of technology and data analytics to manage
liquidity, and hedging, allow firms bring better solutions for the liquidity constraints (Portes & Rey, 2020).
Also, creating an alliance with some first-class international financial organizations or developing branches
in significant economic jurisdictions can further develop firms, strengthen their receive-ability of liquidity,
and eliminate some regulatory hindrances to hedging (Sarno et al. , 2018). In this context, there is a need
for the organisation to implement a systematic approach toward meeting its hedging needs through using
better hedging techniques, incorporating advanced technology and developing suitable partnerships for use
in the Foreign Exchange Markets so as to improve on its Liquidity and Market Access Constraints as well
as the Aspect of Risk Management.
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4.3 Accounting and Regulatory Considerations
In this view, accounting and regulatory issues present complex issues regarding hedge accounting and
especially in financial reporting and compliance (Schoenle & Taylor, 2017). Firm intangible assets such as
ASC 815 (FAS 133) stipulate that firms have to accruals of derivative instruments, which means that
changes in the fair value will have impacts on the income statement hence cause volatility of earnings. As
this shows, such oscillations can influence various aspects of investors’ judgments and market values,
which is why hedging must be ensured to minimize such fluctuations (Rajan & Subramanian, 2019).
Further, compliance costs and bureaucratic hassles are often realized through legal structures, which
provide frameworks for regulating derivatives, including the Basel III Accord and the Dodd-Frank Act, which
may lead to the imposition of capital controls, margining rules, and reporting conventions on derivative
transactions (Portes & Rey, 2020). Satisfying these regulations requires effective risk management
strategies and sound controls to provide suitable policies and reliable reporting that meets legal standards
(Schoenle & Taylor, 2017). In addition, the fluctuations in the regulation processes like Brexit or changes in
the governmental policies might occur, which will create some uncertainties and which requires certain
changes in the hedging processes to meet new regulation requirements (Stock & Watson, 2019). Another
important factor that firms have to take into consideration is the difference in the regulation system amongst
different countries, which would require policy adaptations across the networks that the firm has
established in various jurisdictions (Rajan & Subramanian, 2019). As a result, companies usually work with
and seek the help of lawyers and other legal entities to determine the compliance obligations within
specialized fields or sectors as well as in the development of compliance frameworks compatible with the
international legal norms (Portes & Rey, 2020). In this regard, it is imperative for firms to engage in
consistent monitoring of current regulations and performance of ongoing assessments about their
regulatory implications for hedging activities and strategies while aiming to stay in compliance and manage
existing risk exposures in more fluid global regulatory environments (Schoenle & Taylor, 2017).
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4.4 Costs and Operational Complexities
The costs and other operational factors that are linked to hedging mean that such activities have potential
impacts on firms’ risk management decisions and financial outlooks (Sarno et al. , 2018). Direct costs
include transactions costs such as fees incurred in executing trades, bid-ask spreads in the financial
markets, and margin costs, while indirect costs refer to the opportunity cost of hedging and time spent
supervising and implementing hedging strategies (Schoenle & Taylor, 2017). For instance, the bid-ask
spreads could also depend on market conditions and the flammability of underlying assets when it comes
to hedging and this makes the hedging process expensive or cheap (Stock and Watson, 2019). Further,
legal and regulatory requirements on margins for clearing and for margining with counterparties can lock up
capital that would otherwise be utilized for direct investment or operational expenses resulting in effective
costs of capital (Portes & Rey, 2020). Challenges arise from the need to deal with multiple counter parties,
provide and manage collateral, and effect timely and efficient delivery and payment of the derivative
products (Stock & Watson, 2019). Moreover, regulatory factors enhance the level of challenges which
means that firms must deal with a vast amount of regulations for instance: Dodd-Frank and EMIR that set
some measures regarding reporting, margins as well as clearing in the derivative transactions (Rajan &
Subramanian, 2019). Businesses need to analyze every cost and potential benefit of hedging believing in
factors like the size of its exposure needed to hedge, quality of hedge instruments available, the risk
tolerance of the firm and its financial strength (Portes & Rey, 2020). Furthermore, they should implement
satisfactory standards for controlling operational risks by maintaining strong risk management policies and
regulating and evaluating internal controls and regulations (Rajan & Subramanian, 2019). This make
stretch in creating holistic approach in hedging to cover all possible hedges and its impact to the firm’s
financial status and business aims amid operational issues linked to hedging costs.
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5.0 Integrating Hedging into Risk Management Framework
5.1 Aligning Hedging with Corporate Risk Appetite
It is crucial for hedging activities to be palatable by the company’s risk profile in order to ensure that risk
management compliments the formulated overall strategic goals of the firm as stated in Obstfeld & Rogoff
(2017). Before firms undertake these conversions, assessments of the degree of risk tolerance specific to
currency risk should carried out based on companies solvency, market trends and conditions as well as
competition outlook (Magud & Schumacher, 2017). As a result, it is necessary to define clear Risk Appetite
Statements and outline risk tolerances that need to be followed as a general framework for decision-making
across the organization (Mariano and Murdock, 2017). For instance, while a risk managerial firm may focus
on the maintenance of capital and apply conventional hedging techniques, a risk taking firm may be willing
to take currency risk bearing to higher levels in the quest for more revenues (Martin & Rey, 2019). Through
linking hedge management efforts with the firm’s risk tolerance level, value creation goals will be achieved
since a firm’s hedging policy will be in tune with the firm’s risk management policies and objectives
(Nitschka & Berger, 2018). This alignment promotes a management approach that aligns hedging with the
firm’s overall business strategies, which further aids the firm in the execution of its business aims and
objectives amidst complex and competitive currency risks environments. Furthermore, the effective
alignment also helps firms to adopt a more active approach to the management of risks that is useful when
adjusting to shifts in conditions in the market, and changes appropriate hedge plans (Noy & Ostry, 2018).
Updates and relevancy checks on risk appetite statement are helpful to any firm; this helps firms to keep
changing after a period with the ever changing conditions so as to ensure that hedge activities are well
focused and correspond to the objectives of the firm as set (Oet & Wall, 2017). Moreover, the increased
awareness and admission of risk throughout the enterprise also result in improved discipline and
completeness in risk management across the organization (Ouédraogo & Schimmelpfennig, 2018).
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5.2 Establishing Policies and Governance Structures
Since the practice of hedging calls for strategic decision-making, it is important that companies formulate
sound policies and governance structures that may help in managing their hedging options effectively (Liao
et al. , 2018). Dr Lazarus recommends that firms should establish clear policies regarding the business of
managing currency risk, in form of a charter that addresses the goals, policies, and processes for managing
the risk including the type of hedging instruments allowed, the counterparties allowed, the risk thresholds
together with the reporting framework (Magud & Schumacher, 2017). .In the same way, there must be
structures to facilitate identification of accountability for risk management oversight which includes outlined
roles and responsibilities of the overseer and risk management oversight committees, reporting hierarchy
and escalation path (Mariano & Murdock, 2017). In particular, through the development of policies and
governance structures, it is possible to minimize risk management departures, confusion, conflicts of
interest and compliance violations, and enhance the likelihood of the firm’s actions to be deliberate,
consistent, and uniform (Martin & Rey, 2019). These measures engender general guidelines for
coordinating hedging activities with other risk management goals and organizational strategies, thus
offering a proactive approach to conflict risk and efficient decision making at the firm (Nitschka & Berger,
2018). In addition, sound policiy frameworks and governance structures help to build confidence with the
relevant audiences comprising of investors, regulators and creditors, on the capacities of the firm to
adequately hedge currency risks and protect its financial interest (Noy & Ostry, 2018). Decisions and
actions that firms make should be periodically audited, analyzed and modified according to characteristics
of the market environment, regulations and internal changes (Oet & Wall, 2017). Practice implementation
and enforcement are critical to adequately consider the consistency of hedging effectiveness and
adherence to policies to maintain efficiency in accordance with the firm’s risk tolerance and corporate goals
(Ouédraogo & Schimmelpfennig, 2018).
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5.3 Evaluating Hedge Effectiveness and Performance
It is apparent that Hedge effectiveness and Hedge performance measures are not easily determinable
since the process entails several procedures and assessment tools (Obstfeld & Rogoff, 2017). One of them
is the examination of actual hedge outcomes against various predefined benchmarks/targets to check to
what extent the company’s hedging strategy met all intended objectives (Liao et al. , 2018). It assists in
determining the extent of difference, or lack thereof, from the benchmark to offer an understanding of the
suitability of the hedging instruments, together with the methods used to employ them, (Magud &
Schumacher, 2017). Besides, it is also important to understand the pattern that defines the success or
failure of hedge since pattern analysis also contributes to comprehending the nature of hedge mechanism
(Mariano & Murdock, 2017). Forces like dynamics in the foreign exchange market, shifts in interest rates,
and other political events may impact hedges, therefore, calling for the need for an effective evaluation of
any risks in play (Martin & Rey, 2019). KPIs are equally important in evaluating hedge performance in that
they create clear measures on whether or not a hedge is thriving or struggling in its aim (Nitschka & Berger,
2018). For instance, hedge ratios point out the extent of the exposure that has been effectively hedged and
hedge cost metrics address the cost that is incurred in putting into place the hedge (Noy & Ostry, 2018).
Accrued Hedge P&L estimation provides insight into the husbanding of hedging on the finances of the firm
in question (Oet & Wall, 2017). Moreover, hedge efficiency indices assess the general degree of success in
managing the exposure to risks and bolstering the firm’s financial health (Pagano & Volpin, 2017).
Structural reviews help firms assess how well they have managed their risks and make pertinent changes
to hedge policies (Pritsker, 2017). Self-assessment results can reflect shifts in the internal and external
business environment and allow firms to modify their risk management activities accordingly (Rajan &
Subramanian, 2019). In general, integrated and accurate evaluation procedures are crucial for sustaining
strong risk management systems and implementing them in line with strategic goals (Sarno et al. , 2018).
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5.4 Adapting Strategies to Dynamic Market Conditions
Managing change in conditions includes a number of elements within the firm, and these include
awareness of change, proactivity and adaptation in strategic decision making as mentioned by Nitschka
and Berger (2018). Foreign exchange rates are somewhat influenced by a vast of list factors which includes
economic data and events, political forces, changes in central banks’ monetarist policies, and moods of
speculators (Obstfeld & Rogoff, 2017). Companies need to be prepared and be always on the lookout for
events that may cause fluctuations in the demand and supply of the currencies that affects the currency risk
exposure (Liao et al. , 2018). Thus, the risk management process has to be as swift and responsive as
possible, adjusting hedge ratios, rebalancing hedge portfolios, and even considering different hedging
instruments along with changes in the market environment (Magud & Schumacher, 2017). In addition, firms
should incorporate flexibility as one of the foundational approaches and frameworks of risk management,
which will enable the firms to adequately respond to other losses or various activities that may be out of the
ordinary especially during increased volatility (Mariano & Murdock, 2017). Of particular importance, usage
of advanced analytical techniques and technological tools helps firms to be more knowledgeable
concerning forthcoming market trends in a bid to be in a position to make timely and accurate decisions
(Martin & Rey, 2019). Furthermore, constructing good relations and information sharing on market
occurrences within the organization allows relevant market information to be communicated and decision
making processes to be enhanced positively (Nitschka & Berger, 2018). In addition, to support this idea,
firms should foster long-term relationships with financial institutions, market specialists, and technology
partners to leverage the available and domain-specific knowledge and competencies that can enhance risk
management outcomes (Obtfeld & Rogrff, 2017). The culture of flexibility enables firms to avoid moving
blindly for acceptance in the currency markets while anticipating future challenges to remain relevant,
relevant for success in the challenging currency markets.
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