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Discuss the general issues that should be considered when deciding whether to hedge foreign exchange rate exposure (Rolls Royce example).
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Introduction: Rolls Royce sells aero engine in a number of foreign currencies, principally in US$ and GBP. Revenues are therefore earned in foreign currencies which, when converted to $, are subject to movements in foreign exchange rates. Rolls Royce face several financial risks which include unfavourable movements in interest rate and foreign exchange rates. A firm is said to exhibit exchange rate exposure if its share value is influenced by changes in currency values (Michael Adler and Bernard Dumas (1984)). There are a number of channels through which the exchange rate might affect the profitability of a firm. Firms that export to foreign markets may benefit from a depreciation of the local currency if its products become more affordable to foreign consumers. On the other hand, firms that rely on imported intermediate products may see their profits shrink as a consequence of increasing costs of production. Even firms that do no international business may...
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