Foreign currency fluctuations are one of the key sources of risk in multinational operations. Consider the case of Dell Inc., which operates assembly plants for its computers within the United States as well as in Ireland, Malaysia, China, and Brazil; runs offices and call centers in several other countries; and markets its products in more than 100 countries. Dells currency problems are evident in the fact that it may manufacture a product in Ireland for sale in, say, Denmark and obtain payments in Danish krone. Dell would like to ensure that its foreign profits are not eroded by currency fluctuations. Also, at the end of the year, when Dell consolidates its financial statements for the year in U.S. dollars, it wants to ensure that exchange rate changes do not adversely impact its financial performance.
The pressure to monitor and manage foreign currency risks has led many companies to develop sophisticated computer-based systems to keep track of their foreign exchange exposure and aid in managing that exposure. The general concept of exposure refers to the degree to which a company is affected by exchange rate changes. This impact can be measured in several ways. As so often happens, economists tend to favor one approach to measuring foreign exchange exposure, whereas accountants favor an alternative approach. This chapter deals with the measurement and management of accounting exposure, including both translation and transaction exposure. Management of accounting exposure centers on the concept of hedging. Hedging a particular currency exposure means establishing an offsetting currency position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Regardless of what happens to the future exchange rate, therefore, hedging locks in a dollar (home currency) value for the currency exposure. In this way, hedging can protect a firm from foreign exchange risk, which is the risk of valuation changes resulting from unforeseen currency movements.