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Hi,
The 3rd part of the question is about the issue on a senior member of the treasury taking substantial hedging positions.
So I get it’s about protection against translation risk.
Now a suggested solution states that the translation risk cannot be hedged against. If that’s the case why did the senior member even go for taking hedge positions? I thought the whole point of hedging is to protect against translation risk.
Why does the solution state that translation cannot be hedged against?
Also it says that translation risk doesnt result to cash flow movement. Is this referring to unrealized gains and losses?
Thanks.
I think that maybe you are confusing translation risk with transaction risk.
Transaction risk is when there is going to be a future conversion of cash (e.g. because you will have to pay a supplier in a foreign currency in (say) a months time). The risk is that by the time the transaction occurs, the exchange rate may have changed. This risk can be hedged against. (I don’t know if you have watched them yet, but my free lectures on foreign exchange risk management go through the various ways that transaction risk can be hedged against).
Translation risk is when you have assets and/or liabilities in a foreign currency, which need converting to the home currency in the accounting statements at the year end. From year to year as exchange rates change, the value in the home currency will change. However, this does not directly affect cash flows – it is a ‘paper’ risk (an unrealised gain or loss) – and cannot be hedged against.
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