With the recent volatility in currency markets and in particular the weakness of the US Dollar, many companies are again revisiting their foreign exchange risk management strategy.
Before entering into any financial instrument, companies firstly need to be clear on what they are aiming to achieve from a hedging strategy. Only then should derivatives products be considered.
What is my risk?
There are two basic types of foreign exchange risk:
1. Transactional risk
2. Translational risk
Transactional risk involves actual flows of cash in the future, for example an export or an import. Translational risk involves the foreign exchange difference experienced when re-converting a foreign exchange value into the functional currency of the company concerned. The translation may be in respect of earnings, costs, assets or liabilities. Frequently translation risks turn into transaction risks at a later date as earnings are repatriated or assets and liabilities realised.
