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CHAPTER 9 MANAGING TRANSACTION EXPOSURE AND ECONOMIC EXPOSURE CHAPTER OUTLINE I. Basic Nature of Foreign Exchange Exposures a) Exposure management strategy (1) Forecast the degree of exposure (2) Develop a reporting system to monitor exposure and exchange rate movements (3) Assign responsibility for hedging exposure (4) Select appropriate hedging tools b) Transaction exposure c) Economic exposure d) Comparison of the three exposures II. Transaction Exposure Management a) Forward market hedge b) Money-market hedge c) Options-market hedge d) Swap-market hedge (1) Options versus forward contracts (2) Cross hedging d) Swap agreements (1) Currency swaps (2) Credit swaps (3) Interest rate swaps (4) Back-to-back loans III. Economic Exposure Management a) Diversified production b) Diversified marketing c) Diversified financing d) Summary of economic exposure management IV. Currency Exposure Management Practices a) Relative importance of different exchange exposures b) Use of hedging techniques by MNCs b) A maturity mismatch in MGRM's oil futures hedge V. Summary 69
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CHAPTER OBJECTIVE Chapter 9 discusses the basic nature of foreign exchange exposure and explains how both transaction and economic exposure can be measured and hedged. This chapter also presents the exchange risk management instruments which are used by MNCs to hedge these risks. A maturity mismatch in a German firm’s oil futures hedge is presented as an example of the riskiness of these hedges. KEY TERMS AND CONCEPTS Foreign exchange exposure refers to the possibility that a firm will gain or lose due to changes in exchange rates. Operational techniques are operational approaches to hedging exchange exposure that include diversification of a company’s operations, the balance sheet hedge, and exposure netting. Financial instruments are financial contracts to hedging exchange exposure that include currency forward and futures contracts, currency options, and swap agreements. Transaction exposure refers to the potential change in the value of outstanding obligations due to changes in the exchange rate between the inception of a contract and the settlement of the contract. Economic exposure, also called operating exposure, competitive exposure, or revenue exposure, measures the impact of an exchange rate change on the net present value of expected future cash flows from a foreign investment project. Forward exchange-market hedge involves the exchange of one currency for another at a fixed rate on some future date to hedge transaction exposure. Money-market hedge involves a loan contract and a source of funds to carry out that contract in order to hedge transaction exposure. Swap-market hedge involves an exchange of cash flows in two different currencies between two companies. Cross hedge
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