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Managing foreign exchange risk and its pitfalls

Why are there gains from international diversification without hedging exchange-rate risk even though exchange rates contribute a substantial proportion of overall risk?

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In open market economics, performance of firms depends increasingly on economic and financial variables e.g. exchange rates, commodity prices and interest rates. Therefore every firm is exposed to the unsystematic and systematic risks. Reductions of total risks ensure stability of expected cash flows. Risk management strategies reduce uncertainty of the availability of the internally generated funds to make further value enhancing investments. Despite ensuring the availability of funds when required, risk management does not achieve this through complete insulation from all financial and economic risk variables.
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Solution Summary

This solution explains the various ways of managing foreign exchange risk and the limitations of it.