Glossar

Exchange rate forecasts are quarterly estimations of the future levels of exchange rates over the next four quarters. They are undertaken by economists and currency analysts working for portfolio management firms and investment banks. Exchange rate forecasts are for the most part based on expectations regarding macroeconomic variables, interest rate differentials, sentiment, and even political events. Once these individual forecasts are out, their average —for each currency pair— is presented in a variety of surveys. Some companies incorporate such average forecast exchange rates as ‘budget rates’ for a period. However, given the unpredictable nature of currency moves, the reliability of exchange rate forecasts remains an open question.

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 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.