Question

Exchange Rate Exposure

Explain each of the following types of exchange rate exposures. Provide examples to demonstrate how these work:
Transaction
Translation
Economic
Explain how companies can use each of the following techniques to mitigate exchange rate exposure. Provide examples (the more detailed the better). Indicate what type(s) of foreign exchange exposure your examples mitigate:
Future and forward contracts
Call and put options
Cross-hedging
Money Market hedge
Restructuring operations

Note: In your application of the different hedging techniques include an explanation as to how a company can use futures to hedge both receivables and payables. Indicate whether the company should be purchasing or selling the foreign currency forward for each of these types of transactions.

Answer 1

Transaction Exposure: A Firm has transaction exposure when it has contractual cash flows (receivables and payables) in foreign currency, the home currency equivalent of which is unknown or uncertain. For example, an importer Firm has cash outflows payable to a foreign firm at a future date. The exchange rate prevailing on that future date shall determine the amount of cash outflow for the firm (in home currency). The exchange rate might differ from the rate prevailing on the date on which the firm entered the transaction, leading to a potential loss for the importer (incase the rate increases and the firm has to pay more).

Translation Exposure: This refers to the extent to which the financial reporting of a Firm is affected by a change in exchange rates. For example, Firms have to prepare consolidated financial statements for each year, incorporating the financial statements of its foreign subsidiaries and associates. The assertions have to be converted from foreign currency to domestic currency at the exchange rates specified in conversion rules. As such, this may lead to an increase/decrease in the reported net profits of a Firm and may affect its stock prices.

Economic Exposure: This refers to the extent to which a Firm's market value can be affected due to unexpected exchange rate fluctuations. Certain events can impact the present value of cash flows of a firm, further affecting the intrinsic value of the firm. For example, any change in exchange rates, inflation, Government policies that influence the demand for a commodity in a particular country is an economic exposure for a firm that sells that good.

Futures and forward contracts: These are hedging tools that help a Firm in mitigating a transaction exposure in particular. In this contract, two parties agree to sell or buy an asset at a predetermined price at a future date. Hence, this helps in mitigating the exchange rate exposure.

Call and put options: A call option gives the buyer a right to buy the underlying asset at the exercise price at any time upto the expiration date. Put option gives the buyer a right to sell the underlying asset at the strike price at any time upto the expiration date. These derivatives can be used to hedge exchange rate exposure. A call option is preferred when the investor expects the price of the asset to rise during the time frame, a put option is preferred when the investor expects the price to fall during the said time frame.

Cross hedging: This refers to hedging exposure using two assets which have positively correlated price movements. We take opposite position in both assets, mostly this startegy is given affect to using commodity futures. For eg, if an airline company wishes to mitigate the exposure from rising fuel prices, it can buy futures contacts for fuel and effectively pay a price for their future fuel needs.

Money market hedge: This refers to mitigating exchange rate risk using money market instruments, i.e, highly liquid and short term instruments like treasury bills, bankers' acceptances, commercial paper etc.

Restructuring Operations: This is an effcetive tool to mitigate economic exposure. It focusses on shifting the sources of costs or revenue to other locations in order to match cash inflows and outflows in foreign currencies. This helps in bringing down the uncertainty factor of cash flows .