Question

Describe differing types of currency exchange rate financial risk exposures. Discuss the methods a company may use to reduce the potentially significant negative impact of these different types of current exchange rate exposures on the company’s financial health.

Answer 1

Types of Exchange Rate exposures :

There are three types of broad risks from Forex exposure, viz:

1. Transaction Risk
This pertains to the regular business transactions in forex , and the risk arising from currency fluctuations on the transactions.
For instance debtors , during sale of goods, if the exchange rate falls after sale, the realizable value of the debtors, would be lower than initially recorded and expected.
Also for example , when ECB (external commercial borrowings) are taken, the exchange rate fluctuations can increase or decrease the EMI payments.  

2. Translation Risk
This refers to the reporting value of the P&L and Balance Sheet items changing with the risk exposure.
This has a direct impact on accounting, and accounting profits, and hence the shareholder value.

3. Economic Risk
Volatility in exchange risk affects the market value of the company.
This depends on the markets the company is exposed to , and resultant currency fluctuations affecting the overall value of the company.

Some of the risk Mitigation / Hedging strategies:

1. Forex hedging strategy generally involves holding the opposing position to a trade trying to hedge.
For example to hedge receivables in USD, you hold a put option (since if the value of USD falls, then you may be able to exercise the put to mitigate risk.

2. Multiple currencies, for example if the risk is in INR/USD , hold the opposite USD/ INR position to hedge.

3. Forward , futures and money market instruments are some of the type of instruments used to hedge.   

4. Contractual hedging - This would fix the exchange rate to be exercised, irrespective of the prevailing market rate of the currencies involved.