Final answer:
Exchange rate risk comes in various types, such as transaction, translation, and economic risk. Managers can employ strategies like hedging, forward contracts, and selecting appropriate exchange rate policies to manage these risks. Central bank interventions and policy decisions play a crucial role in stabilizing currency values.
Step-by-step explanation:
Types of Exchange Rate Risk
There are several types of exchange rate risk that international managers must navigate:
- Transaction Risk: Arises from the effect that exchange rate fluctuations have on a company’s obligations for foreign currency-denominated transactions.
- Translation Risk: Occurs when companies consolidate financial statements that include foreign assets and liabilities; the risk is that the exchange rates may vary from one financial reporting period to the next.
- Economic Risk: The risk that a company's market value can be affected by exchange rate changes due to its future cash flows being influenced by currency fluctuations.
Strategies to Manage Exchange Rate Risk
International managers have several strategies at their disposal:
- Hedging: Using financial instruments or market strategies to offset potential losses/gains in another investment.
- Utilizing forward contracts, options, and futures to lock in exchange rates.
- Diversification of currency exposure.
- Balance sheet hedging by matching foreign currency assets and liabilities.
- Internal strategies like invoicing in home currency or adjusting transfer prices.
- Central Bank Interventions: Sometimes central banks intervene in the foreign exchange market to prevent excessive fluctuations.
- Adopting a specific Exchange Rate Policy that best aligns with the company's overall risk management strategy.
Exchange Rate Policy Choices
Choices for exchange rate policy include:
- Allowing the market to determine the exchange rate.
- Occasional central bank intervention to smooth out large fluctuations.
- Guaranteeing a specific exchange rate.
- Sharing a currency with other countries.
Each policy choice has its tradeoffs, and managers must weigh the benefits against the risks.