A primer on the exposure of non-financial corporations to foreign exchange rate risk

In the presence of deviations from parity conditions such as purchasing power parity and the international Fisher effect, non-financial corporations are confronted with risks stemming from the impact of unexpected exchange rate changes on the value of the firm, especially in the short- and the medium-term. The motivation for this paper stems from the authors' dissonance with both the existing academic literature and observed corporate practice, where too much emphasis is placed on either financial assets or hedging instruments, or forecasting rates in the latter case. This paper analyzes the economic exposure of non-financial firms, focusing on cash flows. In this context, issues such as the dimension of pass-through time and other complexities of exposures are explicitly addressed and such considerations in turn are linked to hedging decisions. The role of the competitive environment is stressed and related to analytical concepts such as currency of denomination and currency of determination. Finally, the complexity of the trade-off between financial and operative hedges is emphasized. The overall objective is to pull together diverse strands of the existing academic literature into a clear conceptual framework with the ultimate aim of improving managerial decision-making.