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Transaction exposure (TE) is related to the future cash transaction risks faced by the organization posed by rate fluctuations.
It identifies the degree of TE
It determines if the risk can be hedged.
Once the degree has been found through relative certainty, the firm chooses a hedging technique to secure parts or all the exposure.
Such policies are determined by the management team of the MNC that may choose strategies selectively.
A centralized group consolidates all the related reports to get the expected net position in each foreign currency of the multinational firm.
It reduces the exposure by pricing the exports in the same currency – to get the amount required to pay for its imports.
The firm makes use of futures, forwards, money –market and currency options hedges to lower the risks. They determine the cash flow from each method to conclude the technique to apply for hedging.
To hedge future payables, they acquire currency futures or negotiate a forward contract to buy or sell the currency forwards. In such methods, the real cost of hedging should be used where an accurate predictor of the future spot rate can lower the cost to zero.
Money markets involve money market positions to cover future payables or receivables.
For payable, you borrow the home currency and convert it at the spot rate and invest in the foreign money to pay off at maturity.
For receivables, you borrow the foreign currency and convert the local money at the spot rate and invest at home.
Multinational firms that can accurately predict the foreign cash flows for many years can use long term hedging techniques and long term investment plans, where the long term forward contracts up to 5 years can be set up for the most credible customers.
There are other techniques where the two parties engage the brokers to swap over a specific amount on a pre-determined future date.
In the currency option, the firm can use call or put options to reduce get insulation from adverse market rates in the future.
There can be situations like parallel loans where the exchange of currencies between two parties is made with the promise to re-exchange on a future date at a specific rate.
Drawbacks - Continuous short term hedging may be ineffective and long term international transactions may involve certain factors, resulting in over- protection.
Since one cannot predict future trends to exchange foreign currency, perfect strategies for hedging forex are just not possible and companies may use alternative methods like cross hedging, currency diversification, leading, and lagging.
But cross hedging can be used only when the two types of currencies are highly correlated.
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