Question

J&L Co. is a U.S.-based MNC with net cash inflows of euros and net cash inflows of British pounds. These two currencies are highly correlated in their movements against the dollar. Magent Co. is a U.S.-based MNC that has the same level of net cash flows in these currencies as J&L Co. except that its euros represent net cash outflows. Which firm has a higher exposure to exchange rate risk?

Group of answer choices

the firms have about the same level of exposure

J&L Co.

Magent Co.

neither firm has any exposure

Answer 1

J&L Co. has higher exposure to risk

Explanation:

Before Trading in multiple Forex Pairs, it is very much important to understand Correlation. Correlation Ranges from +1 to -1. When the traded pairs are highly correlated that is +1, this indicated that both pairs move in same direction. If one pair falls in value it is highly possible that other pair will fall in same direction too. In this way the risk gets magnified. For example you take Long Position is EUR/USD and Long in GBP/USD, you have doubled your risk. Both pairs will decrease or increase simultaneously unlike a position where trader is trading in negatively correlated currencies (-1), such situation is used in Hedging Risk Position in the market. As decrease in one pair will result in increase in other hence, resulting in compensating risk.

On the other hand, where Magent Co. is dealing with same currency pairs, but still less exposed to the risk. The reason for the same is that one currency is resulting in inflow of cash funds to company on the contrary other pair is bringing outflows for the company. Here the risk is getting compensated with the opposite position in both the currency. If we have long position in one currency and short in other it will prove as compensatory to the company.