Meaning
Financial vulnerabilities arise when a company has large assets or liabilities in a foreign currency without protective contracts to offset price changes. Unhedged foreign exchange risk exists when the potential loss from a shift in exchange rates is not neutralized by forward contracts, options, or other financial instruments. It applies to any business that buys or sells internationally without a fixed price agreement in its home currency.
Exposure Level
Fluctuations in the value of the domestic currency can lead to unexpected increases in the cost of imported materials or a decrease in the value of export sales. When unhedged foreign exchange risk is high, the company’s profit margins are at the mercy of global currency markets. This volatility makes it difficult to predict the actual return on investment for a production run.
Economic Impact
Sharp devaluations can turn a profitable manufacturing contract into a loss. Managing unhedged foreign exchange risk requires a conscious decision by management to accept the current market rates rather than paying for the cost of a hedge. Small firms often carry this risk because the cost of financial protection exceeds their available budget.
Management Policy
Internal controls usually set limits on the amount of currency exposure a business is allowed to maintain at any one time. Monitoring unhedged foreign exchange risk is a daily task for the treasury department in a multinational corporation. A clear policy on this issue is needed for protecting the long term stability of an industrial operation.
