¶ … currency risk to which the PPP Group was exposed. The paper also considers their options for currency risk management, in particular evaluating how PPP Group can manage their translation exposure risk. Types of Currency Risk

The PPP Group's international transactions subject the firm to currency risk or exchange rate risk which arises with the potential change in the exchange rate of EUR against USD. The PPP Group is exposed to three kinds of currency risk that must be managed: transaction risk, translational rick and economic risk. Transaction risk is associated with the time delay that occurs between PPP Group's entering into contracts to purchase paper supplies and the actual contract settlement. PPP Group is also exposed to translation risk which the is the risk of adverse effects on their financial statements, possibly affecting the company's assets, liabilities, equities or income, due to changes in currency exchange rates. PPP Group is exposed to economic risk, which is the danger that the company may be at a disadvantage and unable to sell the paper bags at a profit if exchange rates move against the company.

Pros and Cons of the Hedging Proposal

The local Chief Executive's proposal to hedge 80% of paper purchases one year in advance is one means of hedging against currency risk. Without hedging, a significant amount of the company's accounts payable remains an unmanaged risk. There are academic studies of currency risk that suggest investors who bear currency risk are not compensated with higher returns, which in effect means that it is essentially needless to bear currency risk. The Chief Executive is well advised to develop some kind of hedging strategy to manage their exposure.

The benefit to PPP Group, or pros, of currency hedging is that it potentially reduces their losses. Hedging protects the...

The disadvantage or cons of hedging is that it also reduces potential profits. If exchange rates were to move in their favor, the PPP Group will not realize those profits. Given that their intent is to reduce exposure as opposed to profit from trading, this is an acceptable tradeoff. Another disadvantage of the Chief Executive's proposed hedging strategy is the associated expenses of hedging which can be significant.
My Recommendation

I considered the following in making a recommendation. The PPP Group has several other financial instruments and combinations of instruments to choose from that will also offset potential losses due to currency risk. These additional means of hedging their currency risk include swaps, options and futures contracts, each with different characteristics that determine how well they meet the PPP Group's risk management strategy. For example, the proposed forward contracts offer more flexibility than exchange-traded futures contracts, in that the forward contracts are negotiated and customizable. Given that all the derivative financial instruments are based on the value of the underlying asset, I recommend that managing forward contracts offers the most straightforward risk management vehicle for the PPP Group.

Factors in Evaluating PPP's Translation Exposure Risk

The PPP Group's translation exposure risk is another result of their currency risk. Because the PPP Group's accounting exposure can affect their assets and liabilities denominated in a foreign currency, as happens with their accounts payable and their accounts receivable, they also need to manage this additional risk. When the parent company prepares its financial statements, it has to report the assets and liabilities that it has in other currencies. The process of valuing foreign assets…