Question

Pretend for a moment that the Mexico wants to hedge against foreign exchange risk derived from transaction exposure.

What could they do to hedge against this type of exposure and protect itself?

Please give me two examples.

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. There are several techniques of hedging this exposure.

• Invoicing - In order to hedge transaction exposure, the invoice or bill should be drawn in home currency (Mexico's currency). This technique will not kill currency exposure. It will only convert transaction exposure into economic exposure.
• Netting - 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.