Due to globalization, companies may have exposure to foreign exchange risk, as u

Question

Due to globalization, companies may have exposure to foreign exchange risk, as unexpected change of exchange rate may affect the settlement of contracts and firm value. Answer the following questions related to foreign currency exposure.

Questions:

(1)List two major differences between transaction exposure and economic exposure.

(2)List two reasons why operational hedging is better than financial hedging in the management of economic exposure.

(3)True or false? “If a company’s revenue and costs/ expenses are in home currency, it does not have any transaction exposure or economic exposure.” Explain.

Explanation / Answer

Solution:

(1) Two major differences between transaction exposure and economic exposure

Transaction Exposure

Economic Exposure

1. It measures the effect of an exchange rate change on outstanding obligations that existed before exchange rates changed but were settled after the exchange rate changes

1. Operating or Economic Exposure is the change in expected cash flows arising because of an unexpected change in exchange rate

2. It deals with cash flows that result from existing contractual obligation

2. It refers to the extent to which the economic value of a company can decline due to changes in exchange rate.

(2)List two reasons why operational hedging is better than financial hedging in the management of economic exposure

Operational hedging is a risk management approach that allows for greater flexibility in how supply chains, product distribution pattern and market facing activities are designed and changed.

Operational hedging can be a powerful tool to minimize the impact of major currency shifts on costs and revenues, while enabling firms to potentially leapfrog less – agile competitors.

(3)True or false? “If a company’s revenue and costs/ expenses are in home currency, it does not have any transaction exposure or economic exposure.” Explain

Risk arises when the currency of revenue and costs are not in home currency. The company has exposure (risk) of change in exchange rate. Hence the statement is true that If a company’s revenue and costs are in home currency it does not have any transaction exposure or economic exposure.

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Transaction Exposure

Economic Exposure

1. It measures the effect of an exchange rate change on outstanding obligations that existed before exchange rates changed but were settled after the exchange rate changes

1. Operating or Economic Exposure is the change in expected cash flows arising because of an unexpected change in exchange rate

2. It deals with cash flows that result from existing contractual obligation

2. It refers to the extent to which the economic value of a company can decline due to changes in exchange rate.

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