TYPE OF FOREIGN EXCHANGE EXPOSURE
A) Transaction exposure
It relates to a firm having a known foreign currency payable/receivable, the home currency equivalent of which is not known with certainty.
B) Operating/economic exposure:
This exposure is an indirect exposure faced by all firms
Case I: Indian firm exporting to US but invoicing in Rupee
Case II: A purely domestic Indian firm ( no export/import) selling goods in India & facing import competition.
Case III: A purely domestic Indian firm ( no export/import) no foreign competition is also affected by exchange rate changes due to interlinked between exchange rate & other macro variables
C) Accounting/Translation exposure
It deals with translation of financial statement of foreign subsidiaries & branches into the parent company home currency. Since no cash flow are involved, it should be notional, however, if markets are inefficient it may effect the share price & is therefore relevant.
TECHNIQUES OF HEDGING TRANSACTION EXPOSURE
| Internal | External |
| Leading & lagging | Forward cover |
| Invoicing | Money market cover |
| Outsourcing | Futures cover |
| Netting | Options cover |
Leading & lagging
The maturity of payable or receivable can be pre-pond or post-pond depending on the strength or weakness of the currency normally it is advisable to:
- Lead the payable in a strong currency
- Lag the payable in a weak currency
- Lag the receivable in a strong currency
- Lead the receivable in a weak currency
Invoicing
Invoicing as a hedging techniques means that an Indian exporter/importer should have the invoice drawn in rupee. Although this will remove transaction exposure it would create economic exposure
Normally invoicing is done in the seller’s currency unless the bargaining power of the buyer is high There can also be the case of dual; invoicing or third currency invoicing
Given a choice regarding the currency of invoicing an Indian exporter should choose that currency which will result in maximum rupee inflow.
Outsourcing
Outsourcing involves importing raw materials from the country to which the firm is exporting. Thus if an Indian firm exports to US, it has $ receivable ( transaction exposure). The firm may create a natural hedge by importing from US. IF it is not possible to import from US, the firm may import from some other country, where currency is significantly positively correlated to $. This is known as the cross hedge.
Netting
This involves netting of the receivable & payable in order to save transaction cost. If there is a maturity mismatched. One can use leading & lagging along with netting to save transaction cost.
Forward contract:
An importer / Exporter has a foreign currency payable/ receivable and is therefore afraid of foreign currency appreciating / Depreciating. To hedge the payable /receivable the importer/ exporter should buy/sell the foreign currency forward. Once the forward contract is entered it is a perfect hedge and the spot rate later on is irrelevant. The decision to go for forward cover or remain unhedged should depend upon a comparison between the forward rates and expected spot rates. If F is favorable the firm should definitely go for forward cover. However if E(S) is favorable the firm may remain unhedged only if its risk tolerance level allows it to take the currency risk.
A company operating in a country having the dollar as its unit of currency has today invoiced sales to an Indian company, the payment being due three months from the date of invoice. The invoice amount is $ 13,750 and at todays spot rate of $ 0.0275 per Re. 1, is equivalent to Rs. 5,00,000.
It is anticipated that the exchange rate will decline by 5% over the three months period and in order to protect the dollar proceeds, the importer proposes to take appropriate action through foreign exchange market.
The three month forward rate is quoted as $ 0.0273 per Re. 1.
You are required to calculate the expected loss and to show, how it can be hedged by forward contract (May 1998).
Money market operation:
In a money market operations, the exposed position in a foreign currency is covered through borrowings or lending in the money market. Money market involves:
Borrowing in FC and invest in HC, in the3 case when FC is to be received in future/export/receivable
Borrowing in HC and invest in FC in the case when FC is to be paid in future/imports/payables
Currency swap:
In a currency swap two parties agree to pay each others debt obligation denominated in different currencies.
A currency swap involves:
An exchange of principal amount today
An exchange of interest payments during the currency of loan
A re-exchange of principal amounts at the time of maturity
Option Forward Contract
This is special type of forward contract in which the customer enjoys the option to buy/sell the foreign currency at any time within a certain future period. The bank therefore quotes either the beginning of the option period or end of option period forward rate which is unfavorable to the customer.
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