Question

Expound the risk sharing, leading and lagging and currency swaps for transactions exposure. We have a billion won that’s payable in one year.

Please focus on what the second part of this means "We have a billion won that’s payable in one year."

Answer 1

Transaction Exposure

Transaction exposure (or translation exposure) is the level of uncertainty businesses involved in international trade face. Specifically, it is the risk that currency exchange rates will fluctuate after a firm has already undertaken a financial obligation. A high level of vulnerability to shifting exchange rates can lead to major capital losses for these international businesses.

One way that firms can limit their exposure to changes in the exchange rate is to implement a hedging strategy. Through hedging using forward rates, they may lock in a favorable rate of currency exchange and avoid exposure to risk.

Risks of Transaction Exposure

The danger of transaction exposure is typically one-sided. Only the business that completes a transaction in a foreign currency may feel the vulnerability. The entity that is receiving or paying a bill using its home currency is not subjected to the same risk. Usually, the buyer agrees to buy the product using foreign money. If this is the case, the hazard comes it that foreign currency should appreciate, costing the buyer to spend more than they had budgeted for the goods.

Real World Example of Transaction Exposure

Suppose that a United States-based company is looking to purchase a product from a company in Germany. The American company agrees to negotiate the deal and pay for the goods using the German company's currency, the euro. Assume that when the U.S. firm begins the process of negotiation, the value of the euro/dollar exchange is a 1-to-1.5 ratio. This rate of exchange equates to one euro being equivalent to 1.50 U.S. dollars (USD).

Once the agreement is complete, the sale might not take place immediately. Meanwhile, the exchange rate may change before the sale is final. This risk of change is transaction exposure. While it is possible that the values of the dollar and the euro may not change, it is also possible that the rates could become more or less favorable for the U.S. company, depending on factors affecting the currency marketplace. More or less favorable rates could result in changes to the exchange rate ratio, such as a more favorable 1-to-1.25 rate or a less favorable 1-to-2 rate.

Regardless of the change in the value of the dollar relative to the euro, the Belgian company experiences no transaction exposure because the deal took place in its local currency. The Belgian company is not affected if it costs the U.S. company more dollars to complete the transaction because the price was set as an amount in euros as dictated by the sales agreement.

Risk sharing

Risk is the probability of an event occurring in a given time period. It's important to remember from the outset that, in this context, risk refers only to an occurrence and not necessarily an adverse event. With that in mind, risk sharing doesn't mean pushing the threat of bad outcomes off on someone else. Rather, it means reducing the likelihood and impact of uncertainty.

Here are a few examples of how you regularly share risk:

• Auto, home, or life insurance, shares risk with other people who do the same.
• Taxes share risk with others so that all can enjoy police, fire, and military protection.
• Retirement funds and Social Security share risk by spreading out investments.

Strategies for Sharing Risk

With only a few exceptions, business leaders and project managers should share risk whenever possible. Most of the time, sharing risk is a win-win scenario where stability is increased for all parties. We'll look at some real-world examples in a minute, but first we should look at some broad strategies.

Diversifying Risk

One strategy for sharing risk is to diversify. To an investor, diversify means to put a little money in a lot of places so that the demise of one investment doesn't wipe out the investor. That strategy has a direct corollary in business risk. In this strategy, a business or project leader allocates resources so that a problem or disruption has minimal impact on other aspects of the business.

Outsourcing Risk

A second common strategy for risk sharing is outsourcing. Outsourcing means taking a business unit or function, removing it from the organization itself, and subsequently contracting another entity to do the work. In many cases, when you outsource services, you are also outsourcing risk. This is especially true when the outsourced function is already far outside the businesses core competency and primary mission.

Examples of Risk Sharing

During a project, risk can be shared with other project participants and resources. Organizations share project risks when everyone understands deliverables and expectations clearly. In business, risk can often be shared by working closely with other business partners in a mutually beneficial partnership. Here are a few real-world examples of risk-sharing through diversity and outsourcing.

Leads And Lags

Leads and lags in international business most commonly refers to the alteration of normal payment or receipts in a foreign exchange transaction based on an expected change in exchange rates. When a corporation or government entity has the ability to control the schedule of payments being received or being made, then that organization may opt to pay earlier than scheduled or delay the payment later than scheduled. These changes would be made in anticipation of capturing the benefit from a change in currency exchange rates. These dynamics hold true both for small and large transactions.

If a company in one country were about to acquire a corporate asset in another country, and the target company's country currency were expected to decrease in value relative to the acquiring company's country, then delaying the purchase would be in the interest of the acquiring company.

A strengthening of the currency being paid out would lead to a decreased payout for the entity in question, while a weakening of the currency would lead to increased costs the longer the payment were delayed. Because it amounts to a timing strategy, Leading and lagging implies risks. A lack of proper execution and may result an unfavorable outcome.

Currency Swap

A currency swap, sometimes referred to as a cross-currency swap, involves the exchange of interest – and sometimes of principal – in one currency for the same in another currency. Interest payments are exchanged at fixed dates through the life of the contract. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company's balance sheet.

Currency swaps were originally done to get around exchange controls, governmental limitations on the purchase and/or sale of currencies. Although nations with weak and/or developing economies generally use foreign exchange controls to limit speculation against their currencies, most developed economies have eliminated controls nowadays.

So swaps are now done most commonly to hedge long-term investments and to change the interest rate exposure of the two parties. Companies doing business abroad often use currency swaps to get more favorable loan rates in the local currency than they could if they borrowed money from a bank in that country.