Other Steps for Managing Foreign Exchange Risk

To manage foreign exchange risk:

• central control of exposure is needed to protect resources efficiently and ensure that each
subunit adopts the correct mix of tactics and strategies
• firms should distinguish between transaction and translation exposure on the one hand, and
economic exposure on the other hand
• firms should attempt to forecast future exchange rates
• firms need to establish good reporting systems so the central finance function can regularly
monitor the firm’s exposure position
• firms should produce monthly foreign exchange exposure reports

CRITICAL THINKING QUESTIONS

You are CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures component
parts for your U.S. assembly operations. The subsidiary has been financed by bank borrowings in the
United States. One of your analysts told you that the Mexican peso is expected to depreciate by 30
percent against the dollar on the foreign exchange markets over the next year. What actions, if any,
should you take?

DERIVATIVES

 Derivatives are products, instruments, or securities which are derived from another security,
cash market, index, or another derivative.
 A derivative instrument (or simply derivative) is, thus, a financial instrument which derives its
value from the value of some other financial instrument or variable. Ex. stock option is a
derivative because it derives its value from the value of a stock.
 A derivative is a financial instrument that offers a return based on the return of some other
underlying asset. Its return is derived from another instrument.
 A derivative’s performance is based on the performance of an underlying asset.
 A derivative contract has a limited life, and its payoff is typically determined and/or made on the
expiration date