Question

(a)What is exchange rate risk? Distinguish between Transaction Exposure and Economic exposure to exchange rate movements.

     (b)Consider the following information:

            90-day U.S interest rate………………………………………………………….4%

            90-day Malaysian interest rate……………………………………………….3%

            90-day forward rate for the Malaysian Ringgit ……………………..$0.400

            Spot Rate of Malaysian Ringgit ………………………………………………$0.404

Assume a U.S based MNC will need 300,000 Ringgit in 90 days and wishes to hedge this payable position. Would it be better off using a FORWARD hedge or MONEY MARKET hedge?     

Answer 1

Answer (a)

Exchange rate risk, also known as currency risk, is the financial risk arising from fluctuations in the value of a base currency against a foreign currency in which a company or individual has assets or obligations.

• Transaction Exposure : This exposure arises when a firm has a known amount of Foreingn Currency payable or receivable, the home currency equivalent of which is not known. This is a direct exposure faced by only a few firms. There are several techniques of hedging this exposure.
• Economic Exposure : This is an indirect exposure which is faced by all the firms. Thus even though a firm may not have any foreign currency payable or receivable, yet it is effected by a change in exchange rate.

The points of difference between both the type of exposures are stated below:

1. Cash Flow

Transaction Exposure is driven by transactions which have already been contracted for and hence they are of short term nature. For example: if Company A, based in the US has already supplied goods worth $100 Mio to another Company B in the UK and has agreed to receive the payment in GBP, it has already undertaken transaction risk on cash flows

Economic Exposure is transaction exposure as well as operating exposure which is related to future cash flows. These cash flows are not realised or contracted for and the exposure is more anticipatory in nature. Economic exposure can arise due to change in future sales, volume, pricing or cost profile.

2. Nature of Risk

In Transaction Exposure, Risk associated is limited to the contract or transaction under discussion.

In Economic Exposure, Risk associated impacts the core value of a business rather than one particular transaction or contract and is the risk to present value of future operating cash flows.

3. Identification

Transaction Risk is the most easily identifiable foreign exchange risk.

Given its anticipatory nature, Economic Exposure is not easy to identify.

Answer (b)

Please refer the attachment for the solution, where the calculation has been done using both the hedging techniques and hence we were able to derive a conclusion that Forward Cover was better.