This is an era of multi-national companies. Almost every business wants to go beyond the boundaries of the nation and explore the market in unknown and unfamiliar economies. The proliferation of the internet medium means that the supplier from one corner of the world can easily reach and market his goods to a customer in another corner. While expanding beyond the restrictions of the domestic borders may bring in rich rewards, the rewards are not without risks. One of the major risks faced by a business operating in multiple countries is foreign exchange risk. Even businesses which operate in one country but import raw materials from or export finished goods to another country also face foreign exchange risk. The volatility in currency exchange rates has increased significantly during the on-going financial crisis and managing foreign exchange risk has attracted a higher level of significance. Financial Models need to account for this risk.
Assumptions related to foreign exchange rates form an important part of financial modeling for such businesses. These assumptions are usually made based on the historic exchange rates for about 5-10 years. While this method may be useful during normal periods, they may prove disastrous to the model during periods of heightened volatility. Another method would be to assume a base rate close to the market rate under the assumption that the company would engage in active or dynamic hedging. While almost all businesses do some kind of hedging, most of them do not cover all of their foreign exchange risk. While the decision to hedge or not to hedge is left to the business-owner / directors to make, the financial modeler should ensure that the models reflect the actual policy to be put to practice.
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