CH09sguide - 9 ManagingTransaction ExposureandEconomic...

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Chapter Objectives 1. To list and discuss the three types of foreign exchange exposure. 2. To discuss the various alternatives in transaction exposure management, including hedges and swaps. 3. To describe the production, marketing, and financing strategies to cope with the economic consequences of exchange rate changes. 4. To discuss how hedging techniques can limit currency exposure. Chapter Outline I. Basic Nature of Foreign Exchange Exposures A. Foreign exchange exposure is the possibility that a firm will gain or lose because of changes in exchange rates. There are three types of exchange exposures: i. Translation exposure, i.e. the account-based changes in consolidated financial statements caused by exchange rate changes. ii. Transaction exposure i.e. changes in exchange rates between the time that an obligation is incurred and the time that it is settled. This affects actual cash flows. iii. Economic exposure reflects the change in the present value of the firm’s future cash flows because of an unexpected change in exchange rates. B. Exposure management strategy involves four steps: i. Forecasting the degree of exposure in each major currency in which the MNC operates. Foreign Exchange Risk Management      110 9 Managing Transaction  Exposure and Economic  Exposure
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ii. Developing a reporting system to monitor exposure and exchange rate movements to assist in protecting the MNC from risk. iii. Assigning responsibility for hedging exposure and determining whether to centralize or decentralize exposure management. iv. Selecting appropriate hedging tools including diversification of the MNCs operations, a balance sheet hedge, and exposure netting. II. Types of Exposure A. Translation exposure is caused by account-based changes in consolidated financial statements that are linked to exchange rate changes. B. Transaction exposure is the potential change in the value of outstanding obligations due to changes in the exchange rate between the beginning of a contract and the settlement of a contract. i. Transactions include credit purchases, credit sales, borrowed funds, loaned funds, receipts, payments, and uncovered forward contracts. All of these transactions may be exposed if they are denominated in foreign currencies. C. Economic exposure, also known as operating exposure, competitive exposure, or revenue exposure, measures the impact of an exchange-rate change on the new present value of expected future cash flows from a foreign investment project. i. This type of exposure is broader and more subjective than either translation or transaction. D. Comparison of the three exposures: i. Management of translation exposure is static and historically oriented but management of transaction and economic exposure is more forward looking because both of these involve actual and potential cash flows. ii.
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CH09sguide - 9 ManagingTransaction ExposureandEconomic...

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