Question

Question 1

a) How can the risk of economic exposure can be mitigated? explain

b) Short term transactions exposure are often easily hedged and corrected shortly to smoothen the impact on cash-flow. Why?

c) Are you in favour of the following sentence? why yes or why not? Give examples of these instruments. There are variety of financial instruments available to hedge the risk of transaction exposure and these opportunities are grown tremendously in recent years.

d) Why in log-run the effect of hedging will be unfavorable to one side of the contract?

e) How can we identify economic exposures?

Answer 1

A) ECONOMIC EXPOSURE CAN BE MITIGATED IN FOLLOWING WAYS:-

1.Diversifying production facilities and market for products.

2.Sourcing flexibility

3.diversifying finance

4.Currency risk sharing agreements

5.Matching currency flows

6.currency swaps

7.back to back loan

B) Short term exposure transaction can be easily hedged as there are variety of hedging instruments are available at varying cost to the company so it can easily be hedged & corrected.The most direct method of eliminating transaction exposure is to hedge the risk with a forward exchange contract.Since short terms transaction exposure is roughly a zero sum game, one party's loss is the other party's gain

It can be corrected through following ways:-

1.Risk shifting

2.Currency risk sharing

3.Leading & lagging

4.Reinvoicing centres

C) yes,There are variety of financial instruments available for heding the risk of transaction exposure an these opportunities are grown tremendously in recent years. For example:-

1.Forward Contracts

2.Future Contracts

3.Money Market Hedge

4.Options

D) Perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost.In lon run it is unfavourable due to following reasons:-

• Hedging involves cost that can eat up the profit.
• Risk and reward are often proportional to one other; thus reducing risk means reducing profits.
• If the market is performing well or moving sidewise, then hedging offer little benefits.
• Trading of options or futures often demand higher account requirements like more capital or balance.
• Hedging is a precise trading strategy and successful hedging requires good trading skills and experience.

E)

The following are the two factors that help in determining economic exposure:

• Economic exposure is higher for firms having both, product prices and input costs sensitive to currency fluctuations. It is lower when costs and prices are not sensitive to currency fluctuations.
• Economic exposure is higher for firms which do not adjust its markets, product mix, and source of inputs in accordance with currency fluctuations. Flexibility in adapting to currency rate fluctuations indicates lesser economic exposure.