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Measuring Foreign Exchange Exposure
Transaction Exposure
Transactions in the form of purchase contracts or agreements
denominated in a foreign currency but not yet settled create
transaction exposure. The fluctuation of the currency will have an
impact on the value until the transaction is completed. The value of
an unsettled export receivable or an import payable is just one
example. There are multiple hedging techniques to help the investor
minimize his risk, including
• forward contracts
• futures contracts
• use of a money market hedge
• contractual risk sharing
• pricing adjustments based on forward rates
• foreign currency accounts
• foreign currency options
Translation Exposure
The revaluation of all foreign-denominated assets and liabilities
often referred to as transfer pricing is usually considered "paper"
gains or losses. The conversion of an asset by selling it and
converting the proceeds to the local currency would create a
realized gain or loss. This form of exposure is created when
financial statements are prepared and converted to the local
currency of the owner or investor. This form of exposure is
considered an indication of potential gains or losses.
Economic Exposure
The evaluation of foreign governments from an economic standpoint
determines whether a translation exposure could be realized. The
projected stability of a country, both politically and economically,
impacts future cash flows and can adversely impact the profitability
of an organization. Strategic planning for operations must include
economic exposure.
Business Needs for Foreign Currency
Accounts Payable and Accounts Receivable
Companies purchase raw materials or component parts for the
manufacturing of goods. When the transaction is conducted in a
currency other than the local currency, risk increases. In order to
control the cost of goods sold and reduce the risk, using some form
of hedge is necessary.
Companies that buy and sell in a foreign currency will often use a
netting effect. The company will maintain a foreign currency account
to deposit funds from sales and to withdraw funds to pay for
purchases. The repatriation of funds generally results in the form
of profits which are converted and transferred to the home office
periodically, thus taking advantage of favorable market conditions.
Interest rates vary widely from country to country. It often makes
sense, depending on the cash position of the company, to take an
equal and opposite foreign exchange exposure position to complete a
transaction at maturity. The company could take out a loan in the
amount of a receivable in the foreign currency, convert it to their
local currency and use the proceeds from their receivable to pay off
their loan. The company may also buy the foreign currency and place
it on deposit with a bank to earn interest and use it to pay off the
payable at maturity. This action will enable the company to fix the
exchange rate and take advantage of favorable investment
opportunities.
A buyer and seller may agree contractually to share the exposure
risk. They can establish different parameters based on market
conditions to control the risk. Parameters can include payment of
goods in the local currency, the splitting of the payment in both
the buyer's and seller's currency, or the inclusion of a price
adjustment clause if the exchange rate changes substantially.
The most common means to control exposure risk is to engage in a
forward contract either in the form of a purchase or sale of a
currency. The forward contract establishes a fixed price to be paid
at maturity on the date the contract is executed. The general
requirement is a small security deposit to secure the completion of
the trade at maturity. Thus the company fixes the price without
using capital until the maturity of the contract. The fixing of the
price of the foreign exchange contract also allows the company to
make a decision today whether to proceed or not based on current
rates. The company can then price the product for sale based on the
actual cost of the components.
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