Skip to content

FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A US airline's fuel is priced in dollars. It competes against a Japanese airline on a route and earns revenue largely in dollars, while the Japanese competitor has yen costs. A sustained fall in the yen against the dollar improves the Japanese competitor's pricing ability. Which hedging approach best addresses the airline's resulting economic exposure?

Economic exposure stems from uncertain, long-term competitive effects of exchange rates, so the best response is operational: shift costs or financing into yen or diversify operations so cash flows offset. Short-term forwards on fixed amounts or hedging contracted items cannot cover this uncontracted exposure.

  1. AShift some costs or financing into yen, or diversify operations, so that cash flows move with the yenCorrect
  2. BBuy a one-year forward contract on a fixed yen amount
  3. CHedge the translation of the Japanese competitor's balance sheet
  4. DHedge only contracted receivables as they appear

Explanation

Economic exposure arises from uncertain long-run competitive effects, so it cannot be neutralised by a short-dated forward on a fixed amount. Operational hedges such as matching yen costs or financing, or diversifying production and sales locations, create offsetting cash flows. Hedging only contracted items or a competitor's balance sheet misses the exposure.

Did you get it right without looking?

One question tells you little. A timed set on How Do Firms Manage Financial Risk? shows your real accuracy, how long you take and where you lose marks.

Practise How Do Firms Manage Financial Risk?Free diagnostic mock

More How Do Firms Manage Financial Risk? questions