Glossaire

Exchange rate risk or foreign currency risk is the possibility that currency fluctuations can affect a firm’s expected future operating cash flows, i.e., its future revenues and costs. For companies desiring to take advantage of the growth opportunities derived from buying and selling in multiple currencies, effectively managing currency risk is an essential task. Exchange rate risk can be decomposed into: Pricing risk Accounting risk Transaction risk Operating risk Pricing risk refers to possible exchange rate fluctuations between the moment a company prices a transaction and the moment it is formally agreed. Accounting risk reflects changes in income statement and balance sheet items caused by currency fluctuations. Transaction risk refers to future FX-denominated cash flows that result from existing, contractually binding firm commitments (sales or purchase orders), whether or not the corresponding receivables/payables have been created. Operating risk measures the extent to which currency fluctuations alter the firm’s future operating cash flows, that is, its future revenues and costs. Finally, economic exposure comprises the two cash flow exposures: transaction exposure and operating exposure.

Exotic currencies are currencies that are thinly traded and highly illiquid. Most exotic currencies are Emerging Market countries’ currencies. They include, among many others, the Armenian Dram (AMD), the Belorusian Ruble (BYR), the Egyptian Pound (EGP), the Indonesian Rupiah (IDR), the Moroccan Dirham (MAD), the Qatari Rial (QAR), the Uzbekistani Som (IZS), etc.. When hedging their FX exposure, risk managers are naturally reluctant to sell exotic currencies that trade at a forward discount because of their high interest rates. But this is counter-productive. Currencies with a high cost of carry tend to be highly volatilite, and refusing to hedge can lead to severe losses. The solution is to calculate a weighted-average rate of all individual pieces of exposure and to build a ‘tolerance’ (in % terms) around that benchmark rate. Then, ‘take-profit’ and ‘stop-loss’ orders are set that allow the firm to effectively delay the execution of the trades, and thus to take shorter-maturity hedges that create savings on the carry.

Exotic options are variations of simple call and put options. Traded in Over-the-Counter (OTC) markets, exotic options allow traders to manage risks in ways that ordinary options cannot achieve. A call option to buy a put option, also known as a Caput option, is a simple example of an exotic option. Other examples include chooser options, allowing a trader to decide whether the contract is a call or a put at some point over the contract’s life. Also, Asian options have no set strike price and are calculated as the average of some price listed in the contract and the market value of the underlying assets. Due to their complex nature, exotic options are not the most suitable products for corporate treasurers wishing to protect their profits from FX risk.