Question

How would you rank the relative importance of transaction exposure, economic exposure, and translation exposure? Explain your answer. If you are the decision maker, will you hedge translation exposure? There are two approaches of hedging: 1) hedge only when we expect an unfavorable movement in foreign exchange rate, and 2) hedge anyway regardless of our expectation of exchange rate movements. Which approach would you use and why?

Answer 1

Foreign Exchange Exposure

Transaction exposure and Economic exposure is the exposure arising out of foreign exchange transactions. It is related to the financial transactions of the company in foreign exchange. But Translation exposure arises out of accounting process of the company. When the financial statements of subsidiary company situated in another country are translated, there translation exposure arises. Transaction exposure is considered as a short term economic exposure where economic exposure is termed as long term in nature. Economic exposure affects the value of the firm.

Ranking:

1. Economic exposure is ranked first since it affets the value of the company for a fairly long period of time

2. Transaction exposure is ranked second as it arises out of each and every foreign exchange transactions of a company. It is a type of economic exposure

3. Translation exposure is ranked third as it arises when the financial statements are translated.

A decision maker may try to hedge Translation exposure, because every exposure is a kind of risk to be hedged.

Approach towards Hedging

The second approach towards hedging is advisible, that is ''hedge anyway regardless of our expectation of exchange rate movements''. Because it is not possible always to predict when the risk may arise and what will be its impact. So it is always better to adopt some hedging strategies to hedge all types of exposure. As a decision maker the unfavourable movements always should be expected.