Topic 5 - Foreign Exchange Exposure and Management Flashcards
How would you define transaction exposure? How is it different from economic exposure?
Transaction exposure is the sensitivity of realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates. Unlike economic exposure, transaction exposure is well-defined and shortterm.
Discuss and compare hedging transaction exposure using the forward contract vs. money market instruments. When do the alternative hedging approaches produce the same result?
Hedging transaction exposure by a forward contract is achieved by selling or buying foreign currency receivables or payables forward. On the other hand, money market hedge is achieved by borrowing or lending the present value of foreign currency receivables or payables, thereby creating offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are equivalent.
What are the advantages of a currency options contract as a hedging tool compared with the forward contract?
The main advantage of using options contracts for hedging is that the hedger can decide whether to exercise options upon observing the realized future exchange rate. Options thus provide a hedge against ex post regret that forward hedger might have to suffer. Hedgers can eliminate the downside risk while retaining the upside potential.
How would you define economic exposure to exchange risk?
Economic exposure can be defined as the possibility that the firm’s cash flows and thus its market value may be affected by the unexpected exchange rate changes.
Discuss the determinants of operating exposure.
The main determinants of a firm’s operating exposure are (i) the structure of the markets in which the firm sources its inputs, such as labor and materials, and sells its products, and (ii) the firm’s ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing.
Discuss the advantages and disadvantages of maintaining multiple manufacturing sites as a hedge against exchange rate exposure.
To establish multiple manufacturing sites can be effective in managing exchange risk exposure, but it can be costly because the firm may not be able to take advantage of the economy of scale.
The exchange rate uncertainty may not necessarily mean that firms face exchange risk exposure. Explain why this may be the case.
A firm can have a natural hedging position due to, for example, diversified markets, flexible sourcing capabilities, etc. In addition, to the extent that the PPP holds, nominal exchange rate changes do not influence firms’ competitive positions. Under these circumstances, firms do not need to worry about exchange risk exposure.
what type of asset is a contract?
asset that represents claim on future cash flows
transaction exposure
the profitability of transactions are affected by unanticipated changes in exchange rate
what are areas of transaction exposure?
- formal contract/agreement
- denominated in foreign currency
what are homogenous goods?
characterized by worldwide uniformity
exposure netting
risk manager determines the total matching long and short positions in contractual currencies and calculates the net exposure that must be managed
exposure management strategies
- contractual hedges
- operational hedges
contractual hedge examples
- money market hedge
- forwards
- futures
- options
operational strategies
- transaction management
- reinvoicing centers
- cash management centers
