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(a) Foreign exchange exposure can be defined as the vulnerability of the group to risk arising
from its transactions denominated in more than one currency. For an international company,
exposure may arise in three ways:
i. Transaction exposure. This arises as a result of the time taken to complete normal trading
transactions. For example, there is normally a time delay between invoicing and receipt
of payment. During this time the exchange rate may move against the supplier causing a
loss to be made in the settlement of the account and its conversion into a different
currency.
ii. Translation exposure. This arises when the group holds assets and liabilities which a
denominated in different currencies. The value of these items will fluctuate with the
exchange rate and this may influence lenders and investors in their dealings with the
group.
iii. Economic exposure. This relates to the longer term competitiveness of the group and
arises from the economic performance of the countries in which the group operates and
with which it trades. For example, the group might decide to serve the European
market from a facility in France. If the franc strengthens, then the competitiveness of
the operation will be eroded.
(b) The precise policy to be adopted will depend on the group's attitude to risk. Difference
approaches and techniques are available to handle the different types of exposure described
above.
i. Transaction exposure
(1) Forward exchange contracts can be used to arrange to buy or sell currency at a
predetermined future date and rate. Such contracts can be matched to known
future operational transactions to reduce the uncertainties associated with
exposure. However, the group may miss the opportunity to make a profit on the
exchange rate.
(2) Matching receipts and payments in a given currency, generally using a bank
account denominated in that currency, is another means of minimizing exposure to risk.
(3) Using the currency market to borrow or lend amounts in local currency
immediately which will subsequently be offset against the payment or receipt
which has to be made in the future.
(4) Currency options can be useful in situations where the actual date and amount of
the transaction are uncertain, for example where the company issues a price list in
a local currency. the company buys an option to buy or sell currency at an agreed
rate and date in the future. If exchange rate movements are unfavorable, the
option can be abandoned. Options are expensive, but they do allow the
company to take advantage of any favorable movements in rates as well as
avoiding any losses.
(5) Currency swaps may be made directly with another company or through a bank.
The futures market can be used to hedge against possible gains or losses on
exchange.
ii. Translation exposure can be minimized by ensuring that as far as possible assets and
liabilities denominated in given currencies are held in balanced amounts. However, if
the group is willing to tolerate a higher level of risk then it may try to arrange its financial
structure to take advantage of the relative strengthening or weakening of the different
economies.
iii. Economic exposure is harder to avoid since much longer term decisions are involved, such as where
to locate production facilities. However it can be reduced by diversifying the trading base across
different countries. Capital structure decisions will also be important.
Kavungya answered the question on April 15, 2021 at 19:15
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