We now come to the problem of managing exposure by means of hedging. As mentioned earlier, hedging a particular currency exposure means establishing an offsetting currency position so as to lock in a dollar (home currency) value for the currency exposure and thereby eliminate the risk posed by currency fluctuations. A variety of hedging techniques are available for managing exposure, but before a firm uses them it must decide on which exposures to manage and how to manage them. Addressing these issues successfully requires an operational set of goals for those involved in exchange risk management. Failure to set out objectives can lead to possibly conflicting and costly actions on the part of employees. Although many firms do have objectives, their goals are often so vague and simplistic (e.g., “eliminate all exposure” or “minimize reported foreign exchange losses”) that they provide little realistic guidance to managers.1 For example, should an employee told to eliminate all exposure do so by using forward contracts and currency options or by borrowing in the local currency? And if hedging is not possible in a particular currency, should sales in that currency be forgone even if it means losing potential profits? The latter policy is likely to present a manager with the dilemma of choosing between the goals of increased profits and reduced exchange losses. Moreover, reducing translation exposure could increase transaction exposure and vice versa. What trade-offs, if any, should a manager be willing to make between these two types of exposure?
These and similar questions demonstrate the need for a coherent and effective strategy. The following elements are suggested for an effective exposure management strategy:2
1. Determine the types of exposure to be monitored.
2. Formulate corporate objectives and give guidance in resolving potential conflicts in objectives.
3. Ensure that these corporate objectives are consistent with maximizing shareholder value and can be implemented.
4. Clearly specify who is responsible for which exposures, and detail the criteria by which each manager is to be judged.
5. Make explicit any constraints on the use of exposure-management techniques, such as limitations on entering into forward contracts.
6. Identify the channels by which exchange rate considerations are incorporated into operating decisions that will affect the firm’s exchange risk posture.
7. Develop a system for monitoring and evaluating exchange risk management activities.