Question

1. in international finance, what is exchange rate definition in general sense? explain the three types of foreign exchange exposure ?

Answer 1

Exchange Rate:- Exchange rate refers to the price of one currency in terms of another currency. There are two types of quotation:- Direct Quote means one foreign currency equals to how much units of home currency and Indirect quote means one home currency equals to how many units of foreign currency.

Example:- For USA, American Dollars is home currency and others are foreign currency.

Foreign Currency Exposure:-

(a) Transaction Exposure (Direct Exposure):- In this, firm knows amount of foreign currency payable or receivable. It is faced by only a few firms who enters either into export or import or borrow the funds in foreign currency or investment in foreign assets like foreign stocks. Because of known amount of foreign currency, it is easy to hedge.

(b) Economic Exposure (Operating Exposure):- It is faced by all firms and it is indirect in nature. It arises without having foreign currency payable or receivable. For example : USA firm is exporting to Indian based firm and invoicing in $ 1,00,000. If dollar price increase from 50 to 75, rupee equivalent price for indian buyer rises from 50 lakhs to 75 lakhs i.e. increase by 50%. If elascity of demand stands for 0.5, demand for this product will decrease by 50% * 0.5 = 25%. So economic exposure is difficult to measure and hedged.

(c) Translation Exposure (Accounting):- It relates to the translation of financial statement of foreign susidiary or branches into parent firm home currency. Since no actual cash flow is involved, accounting exposure is notional and need not be hedged.