Definition of the Goal of Risk Management

According to the theories of exchange rate movements show that the four way equivalence of foreign exchange exposure and how will reduce the risks on the different forms of risks i.e. Transaction, Translation and Economic exposures.

According to PPP Movements in exchange rate offset price level changes. If PPP were to hold immutably and with no time lag, there world, so the argument goes, because no such thing as exposure rate risk and consequently no need to hedge. If the annual rate of inflation in Britain is 10% higher than that in US, the pound will depreciate against the USD by an appropriate % rate. As a result, then is no relative price risk.

According to Capital Asset Pricing Model (CAPM), well diversified international investor should not be willing to pay a premium for corporate hedging activities which they, themselves, can readily replicate by adjusting their own portfolios. Hedging to reduce overall variability of cash flow and profits may be important to managers, compensated accordingly to short-term results, but it is irrelevant to diversified shareholders. The ups and downs of individual investments are compensated by holding a well diversified portfolio.

CAPM suggests that what matters in share pricing is systematic risk. If exchange risk and interest risk are considered to be unsystematic. Then the effect can be diversified anyway by holding a balanced portfolio. On the other hand, if they are systematic and if forward and interest rate instruments are priced according to CAPM, then all that the firm does by entering into hedging contracts is to move along the Security Market Line (SML).

Creditors may be concerned with total variability of cash flows where default is possible, gains and losses that the firm experiences due to random currency fluctuations may influence valuation through the effect on debt capacity. Where total variability is important, hedging in the foreign exchange market may add to the firm’s debt capacity.

Modigliani and Miller (MM) can also array against hedging. MM argue in respect of gearing, that the investor can manufacture home-made leverage which achieves the same result as corporate gearing. The same kind of argument apprise in respect of Individual hedging vs. Corporate hedging. In other words, home made hedging, world made corporate hedging irrelevant. But there are counter arguments here too. Hedging market are wholesale markets and corporate hedging may, therefore, be cheaper. Furthermore, some hedging techniques are only available to the company – leading and lagging and Transfer pricing to name but two. Hedging requires information about current and future exposures and contingent exposures too and it is doubtful whether investors have anything like.