Question

Internal techniques (non-derivative techniques) that the company can use to manage its foreign exchange exposures. Mention the advantages and disadvantages of using each of the techniques that you discuss.

Answer 1

Internal techniques that the company can use to manage it's foreign exchange exposures are as follows:

1.Leading and lagging:- This method works by adjusting the payments required reflecting future currency movements. It is a zero-sum game as if your receivables currency is delayed then you can counter it by delaying the payment in payables. It is a technique used for balancing the delay in payment between the receivable and payable. It can not be fruitful when company is on a gaining position and receivables are on high.

2. Natural hedging:-​​​​​​-The relationship between revenues and costs of a foreign subsidary sometimes provides hedge as it provides the firm with a natural hedge against any fluctuations in foreign exchanges.The disadvantage associated with this method is that it is not a consistent method and it cannot be reliable.

3. Cross hedging:- It is a technique used when  a conversion consists of more than one currency.For example , If an indian exporter has to receive the money in USD dollars and if it cannot be directly converted into INR so it can first be converted into Chinese yuan and then it can be converted into INR.

4. Risk sharing:- ​​​​​​ It is a technique in which the seller and the buyer agrees to share the currency risk in order to maintain the long term relationship between them.This can only be fruitful for relationship building because either of the parties cannot bear losses on behalf of other.

5. Payment Netting- It is a concept in which payment in different currencies are netted by the company and it try to pay out with single stream of payment which negate the fluctuations in foreign currency exchange rates. It also allows to reduce the overall transaction cost. It is not fruitful when the company is into a commanding position as it can even swipe away with any kind of gains.