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Transaction risk exposure (What (Contracts on b/s are accounting exposure,…
Transaction risk exposure
Arises from
Purchasing/ lending credit in foreign currency
Borrowing/lending funds involve foreign currency
Being a party to an uncompleted FX forward contract
Acquiring assets/ incurring liabilities in foreign currency
What
Contracts on b/s are accounting exposure, contracts not yet on b/s is operating exposure
Mixes retrospective & prospective on activities that occur in the past but will be settled in the future
Eg: importer has contracted to buy goods in USD, USD may increase against local currency & make transaction less profitable
Eg: international trade transaction
Exposure measured on currency basis= differences between fixed future CF inflows & outflows
Value will change due to FX rate movements between date of contract singing & settlement date
Currency collars
Buying a collar (put & call) cover both extremes of FX changes
Combines OTM put option & OTM call
As OTM option's strike price is distant from current spot rate, less expensive
Exposure netting
Entails denominating contracts in those FX currencies that would minimise this exposure
Exposure in one currency would be offset by exposure in another
Net gain/loss on entire currency exposure is what matters rather than gain/loss on particular currency
Forward market hedge
Firm with long exposure (positive net exposure) in a foreign currency will sell to offset this position
Done via forward contract in FX market/ as futures contract.
Cross-hedging
Entails purchasing a forward contract in different but strongly related currency
Issue: degree to which the currencies are correlated
Change in their relationship will negate this cover
Foreign currency option hedging
Useful for short term exposures where the end exposure is uncertain
Options have the advantage of expiring without the need for settlement. Suggest in contract bidding
Purchase put option, establish short position
Purchase call option, establish long option.
Currency risk sharing
Protect against FX movements, includes neutral zone, normal FX spot +/- where no action is taken
Contract with FX price adjustment clause can adjust the initially agreed price to reflect certain FX rate changes
Risk shifting via invoicing
Zero sum game: well informed customers & suppliers are unlikely to play
Invoice exports in strong currencies, denominate imports in weak currencies