Free Online Course in International BusinessMeasuring Foreign Exchange ExposureTransaction ExposureTransactions 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 ExposureThe 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 ExposureThe 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 CurrencyAccounts Payable and Accounts ReceivableCompanies 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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