Question

Question 18

1. Give one argument in favor of hedging transaction exposure and one argument against hedging transaction exposure.

Answer 1

Transaction exposure - This exposure arises when someone has a known amount of foreign currency payable or receivable, the home currency equivalent of which is not known. This is a direct exposure faced by few firms.

In favor of hedging transaction exposure

Netting is one of the techniques to hedge transaction exposure. Whenever we have receivable and payable in the same currency, we should not settle them separately. We should make net settlement. This will result in savings of the transaction cost i.e. bid-ask spread on the common amount. Example - We have USD 70,000 payable and $40,000 receivable with respect to a US firm. Suppose the spot rate is Mexican Peso / US Dollar = 41.20 / 41.80. The Mexican firm should make net payment of $70,000 - $40,000 = $30,000. This will save the Mexican firm (41.80 - 41.20) * 30,000 = USD 18,000.

Against hedging transaction exposure

There might be instances where the management may not be able to correctly hedge transaction exposure. As a result of it the cost of hedging might be significant which has to be ultimately borne by the shareholders. Thus inability of the management to enter into a correct hedge may prove costly to the shareholders.

For example - Suppose an Indian company has $100,000 payable in two months. It is afraid of the dollar price rising. Thus it enters into a forward buy contract to purchase $100,000 and safeguard it against the rising Rupee/Dollar rate. However after two months the spot prices of Rupee/Dollar falls significantly and thus as a result of hedging the Indian company has to pay more because it already entered into a forward contract. Had it kept the exposure unhedged it would have paid lower amounts than what it actually had to pay due to forward cover.