MANAGING TRANSACTION EXPOSURE

The various methods available to a firm to hedge its transaction exposure are:

· Forward Market Hedge

In a Forward Market Hedge, a company that is long in a foreign currency will sell the foreign currency forward, whereas a company that is short in a foreign currency will buy the currency forward. In this way the company can fix the dollar value of future foreign currency cash flow.

If funds to fulfill the forward contract are available on hand or are due to be received by the business, the hedge is considered “Covered” “Perfect” or “Square” because no residual foreign exchange risk exists.

Funds on hand or to be received are matched by funds to be paid. In situations where funds to fulfill the contract are not available but have to be purchased in the spot market at some future date, such a hedge is considered to be “ Open” or “Uncovered”. It involves considerable risk as the hedger purchases foreign exchange at an uncertain future spot rate in order to fulfill the forward contract.

· Money Market Hedge

A Money Market Hedge involves simultaneous borrowing & lending activities in two different currencies to lock in the home currency value of a future foreign cash flow. The simultaneous borrowing & lending activities enable a company to crate a home-made forward contract.

The firm seeking the money market hedge borrows in one currency & exchanges the proceeds for another currency. If the funds to repay the loan are generated from business operation then the money market hedge is covered. Otherwise, if the funds to repay the loan are purchased in the foreign exchange spot market then the money market hedge is uncovered or open.