Question

It is absolutely critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals. Foreign exchange risk can be divided into three main categories: transaction exposure, translation exposure, and economic exposure. Talk about some ways that risk in these three areas can be minimized.

Answer 1

Transaction Exposure

It involves the risk that when a business transaction for a company with international operations is arranged in a foreign currency, there is always a risk that the value of that currency may change before the transaction is initiated. If the foreign currency appreciate, it will cost more in the company’s home currency.

The threat of transaction exposure is typically one-sided. Only the business that has to pay/receive in a foreign currency may feel the vulnerability. The entity that is receiving or paying using its home currency is not subjected to the transaction risk.

The company can hedge its risk through any of the techniques :

currency future : These are futures contracts for currencies that specify the price of exchanging one currency for another at some specified future date. These contracts are used to hedge the risk of receiving payments in a foreign currency in future.

options : It is a contract under which the buyer gets the right, but not the obligation, to buy or sell an underlying asset or instrument to/ from the option writer at a specified strike price prior to or on a specified date.

Currency swaps. : This method involves two firms that borrow currencies in the credit market where each can benefit from the best rates and then swap the proceeds according to their needs.

Matching inflows and outflows in same currency : This technique requires matching cash outflows for the sake of inputs and inflows from the sales with the same currency. The business should conduct as much business as possible in one currency only.

Translation exposure

Translation risk is the exposure that leads to financial gain or loss that is not a result of a change in assets but because of a change in the current value of the assets based on exchange rate fluctuations.

A number of mechanisms are available that allow a company to use hedging in order to lower the risk created by translation exposure. Companies can attempt to minimize this type of foreign exchange risk by purchasing currency swaps or hedging through futures contracts. In addition, a company can ask clients to pay for goods and services in the local currency of the company. This way, the risk attached to local currency fluctuation is not borne by the company but is transferred to the client who is responsible for making the currency exchange before conducting business with the company.

ECONOMIC EXPOSURE

The risk of economic exposure can be hedged by two ways, operational strategies or currency risk mitigation strategies.

TYPES OF OPERATIONAL STRATEGIES

1. DIVERSIFYING PRODUCTION FACILITIES AND MARKETS FOR PRODUCTS

Diversifying the production facilities and sales to a number of markets rather than focusing on one or two markets would minimize the risk inherent. However, in such cases, the companies might have to let go the advantage achieved by economies of scale.

2. SOURCING FLEXIBILITY

Companies may look for alternative sources for acquiring key inputs for production. The substitute sources can be considered in case the exchange rate fluctuations make the inputs expensive from one specific region.

3. DIVERSIFYING FINANCING

A company needs to look for access to different capital markets which enables the company to gain flexibility in raising capital from the market with the cheapest cost of funds.

TYPES OF CURRENCY RISK MITIGATION STRATEGIES

1. MATCHING CURRENCY FLOWS

This is the simplest form of minimizing economic exposure by matching foreign currency-denominated inflows and outflows. For example, if a European company has considerable inflows in US dollars and is considering to raise debt, it should try to borrow in US dollars.

2. CURRENCY RISK-SHARING AGREEMENTS

An agreement is formed between the two parties involved in the purchase and sales contract. The agreement states that the parties will have to share the risk arising from the foreign exchange rate fluctuations. The agreement includes a price adjustment clause which states that the base price of the transaction will be adjusted appropriately for the currency rate fluctuations.

3. BACK-TO-BACK LOANS

Under this method, (also known as credit swap) involves two companies located in different countries entering into an agreement to borrow each other’s currency for a fixed period of time. After the termination of the defined period, the currencies are repaid to each other.

4. CURRENCY SWAPS

The currency swap method is very much similar to the earlier discussed method of back-to-back loans, however, it is not reflected on the balance sheet. This method involves two firms that borrow currencies in the credit market where each can benefit from the best rates and then swap the proceeds according to their needs.