Question

Provide at least two examples on ways that companies can mitigate translation and economic exposure (one example for each)

Answer 1

A] Economic Exposure:

Definition : Economic exposure, also known as operating exposure refers to an effect caused on a company’s cash flows due to unexpected currency rate fluctuations.

Company can mitigate economic exposure through:

1. Operational strategies: most involve diversifying production centres, sourcing facilities and financing. Expanding the range of production facilities, providers and sources of finance minimize a company’s dependence on any given currency.

2. Currency risk mitigation strategies: from common forward and futures contracts to more sophisticated dynamic hedging strategies, currency swaps, currency risk sharing with the client and credit swaps between companies located in different countries.

3. SOURCING FLEXIBILITY: Companies may have alternative sources for acquiring key inputs. The substitute sources can be utilized in case the exchange rate fluctuations make the inputs expensive from one region.

4. MATCHING CURRENCY FLOWS : This is the simplest form of mitigating economic exposure by matching foreign currency inflows and outflows. For example, if a European company has significant inflows in US dollars and is looking to raise debt, it should consider borrowing in US dollars.

B] Translation Exposure:

Definition : Translation Risk is the risk of change in the financial position of the company (assets, liabilities, equity) due to exchange rate changes and is usually seen while reporting the consolidated financial statements of multiple subsidiaries operating overseas in domestic currency.

Company can mitigate Translation exposure through:

1. CURRENCY SWAPS : Currency swaps are a settlement between two entities to exchange cash flows denominated for a particular currency for a fixed time frame. Currency amounts are swapped for a predetermined period and interest is paid during that time span.

2. CURRENCY OPTIONS : The Currency option gives the right to the party to exchange the amount of a particular currency at an agreed exchange rate. However, the party is not obligated to do so. Nevertheless, the transactions must be conducted on or before a set date in the future.

3. FORWARD CONTRACTS : Under the forward contracts, two entities fix a specific exchange rate for the interchange of two currencies for a future date. The settlement for the agreed amount of currencies is conducted on the particular future date which is pre-decided.