May 2018 Q3 b.

Transaction exposure – This arises from the effect that exchange rate fluctuations have on a company’s obligations to make or receive payments denominated in foreign currency. This type of exposure is short-term to medium-term in nature. Transaction exposure is driven by transactions which have already been contracted for and hence they are of short term nature. For example: if Company A, based in the US has already supplied goods worth $100 Mio to another Company B in the UK and has agreed to receive the payment in GBP, it has already undertaken transaction risk on cash flows.

Economic (or operating) exposure – This is lesser-known than the previous two, but is a significant risk nevertheless. It is caused by the effect of unexpected currency fluctuations on a company’s future cash flows and market value, and is long-term in nature. The impact can be substantial, as unanticipated exchange rate changes can greatly affect a company’s competitive position, even if it does not operate or sell overseas. For example, a Ghanaian furniture manufacturer who only sells locally still has to contend with imports from Asia and Europe, which may get cheaper and thus more competitive if the dollar strengthens markedly.

The most common methods for hedging transaction exposures are −

• Forward Contracts − If a firm has to pay (receive) some fixed amount of foreign currency in the future (a date), it can obtain a contract now that denotes a price by which it can buy (sell) the foreign currency in the future (the date). This removes the uncertainty of future home currency value of the liability (asset) into a certain value.
• Futures Contracts − These are similar to forward contracts in function. Futures contracts are usually exchange traded and they have standardized and limited contract sizes, maturity dates, initial collateral, and several other features. In general, it is not possible to exactly offset the position to fully eliminate the exposure.
• Money Market Hedge − Also called as synthetic forward contract, this method uses the fact that the forward price must be equal to the current spot exchange rate multiplied by the ratio of the given currencies’ riskless returns. It is also a form of financing the foreign currency transaction. It converts the obligation to a domestic-currency payable and removes all exchange risks.
• Options − A foreign currency option is a contract that has an upfront fee, and offers the owner the right, but not an obligation, to trade currencies in a specified quantity, price, and time period.
• Risk Shifting − The most obvious way is to not have any exposure. By invoicing all parts of the transactions in the home currency, the firm can avoid transaction exposure completely. However, it is not possible in all cases.
• Currency risk sharing − The two parties can share the transaction risk. As the short-term transaction exposure is nearly a zero sum game, one party loses and the other party gains.
• Leading and Lagging − It involves playing with the time of the foreign currency cash flows. When the foreign currency (in which the nominal contract is denominated) is appreciating, pay off the liabilities early and collect the receivables later. The first is known as leading and the latter is called lagging.
• Reinvoicing Centers − A reinvoicing center is a third-party corporate subsidiary that uses to manage one location for all transaction exposure from intra-company trade. In a reinvoicing center, the transactions are carried out in the domestic currency, and hence, the reinvoicing center suffers from all the transaction exposure.
• Netting