Question

1. Discuss whether you think, or rather when you think, a firm should hedge a transaction exposure. Discuss the point of contingency exposure. What is a Re-invoice center and what is the lead-lag strategy of hedging currency exposure? Lastly, when is it most appropriate to use a money-market or forward market hedge but not an options market hedge?

Answer 1

A firm should always hedge a transaction exposure because the firms principle business in not to gain or lose from the change in foreign exchange rate. A firm must always fully hedge its transaction exposure an focus on its core business operations.

Contingency exposure focus is on the items which will have the impact on the cash flows of the firm and whose values are not contractually fixed in foreign currency terms

Re-invoice centre act as a intermediary between subsidiaries of MNC's operating in different countries, re-invoice centre bill and pay all invoices in the currency of the originating country and then re-invoice the affiliate branches in the local currency.

Lead-lag strategy of hedging currency exposure - this strategy involves leading payables and lagging recievables in strong currencies and vice versa.

Hedging transaction exposure through options is a costly strategy and should be used only when volatility of currency is very high, in other cases it is most probable option will lapse out of the money.