Managing Transaction Exposure Adopting Ace Techniques

Managing Transaction Exposure Adopting Ace Techniques

30 Aug 2019 03:13 PM
 

What is Transaction Exposure?

Transaction Exposure refers to the risk or vulnerability encountered by organizations or individuals engaged in international trade whose transactions denominated in a foreign currency are exposed to foreign currency exchange rate fluctuations and forex losses. This can impact corporations' bottom line and cause huge capital losses to organizations due to the changes in the value of forex rates. However, transaction risk can be one-sided in nature -only affecting the businesses completing transactions in foreign currencies but not the firms that pay or receive the bills in home currency. 

Let us understand this with the help of an example. Assume that a United States-based organization is planning to enter a trade agreement with a German organization by purchasing a product from them. The American organization consents to an arrangement of paying the German organization in their home currency, i.e. the Euro, while purchasing the product. Assume that at the time of negotiations between the two companies, the exchange rate of the currencies is a 1-to-1.5 ratio meaning that one Euro is equivalent to 1.50 US dollars ( 1 Euro = $1.50).   

Upon entering the agreement by both parties, the sale won't happen right away with the possibility that the exchange rate might fluctuate in the interim. Thus, exposing the US-based company to transaction exposure. While there is a possibility that the exchange rate of the dollar and the Euro may not change, it is also highly probable that the forex rates could turn disadvantageous for the US organization, contingent upon factors influencing the forex market. Irrespective of the impact of movements of the exchange rates on the American organization regarding its payables, the German organization encounters no transaction exposure because the transaction occurred in its home currency. As dictated by the sales agreement, the German organization is receiving its payment in Euro at a fixed price, hence remains unaffected by the forex market movements and whether the American company is paying more in US dollars or not for completing the transaction.

What causes Transaction Exposure?

Transaction exposure refers to the profits and losses an organization is exposed to for their forex transactions due to the forex market driven foreign currency exchange rate fluctuations. Hence, the primary force that drives organizations and individuals to face transaction exposure is the forex market volatility. First of all, there is no centralized body governing the forex market, witnessing a daily trade volume of over $5 trillion made up of participation witnessed worldwide. Various factors such as the balance of payment, terms of exchange, inflation, and interest costs, dictate the forex market's movements and thereby forex rates. Upon encountering transaction exposure, the unfavourable or favourable changes in the forex rates can impact the value of an organization's receivables and payables. Therefore rather than worrying about the potential losses in your business than can be caused by the forex market movements, the focus should be on implementing the right strategy of forex risk management utilizing the correct hedging instruments to secure one's existing or anticipated positions in the forex market.

Methods to Hedge Transaction Exposure

Implementation of the right hedging strategies by organizations and individuals is essential to avoid ineffective results leading to wastage of time and money. While devising and choosing the right forex risk management method, the core focus should be on accomplishing the organization's objectives instead of engaging in speculations. Following are the different tools that can be utilized to currency hedge against transaction exposure.:

  1. Forward Contracts

    A forward contract is a contractual agreement between two parties for the exchange of currencies at a predetermined exchange rate for a specific date in the future. They are popularly utilized to lock in foreign exchange rates for future completion of transactions and thus fortify against the forex rate fluctuation it is exposed to in the interim. Forward contracts are non-standardized as they are not traded on centralized exchanges. Also, they are over the counter contracts as they are customized between two parties negotiated to consider the risk and returns of both the parties. For example, let us assume that Company A in the United States wants to acquire machine tools from Company B, which is situated in France. At this point, the exchange rate stands at 1 Euro = 1.28 US dollars. Any changes in the exchange between the US dollar and the Euro may impact the cost of the purchase to go either up or down. To avoid a situation of encountering unforeseen losses by both the parties, the exporter in France and the merchant in the US concur upon an exchange rate of 1 Euro = $1.30 for the completion of a transaction bound to happen at a specified date in the future. 

    In the event that the forex rate moves to 1.33 US dollars per 1 Euro in the future, the buyer would have profited by securing or locking in an exchange rate of 1 Euro = $1.30. However, if the future exchange rate is 1.22 US dollars for 1 Euro at the time of transaction completion, then the merchant will profit from the currency forward contract. Nonetheless, the two counterparties have profited by securing the exchange rate as the buyer is aware of the cost incurred for necessary payments, and the supplier precisely knows the value of its receivables. 

  2. Future Contracts
    Besides the forward contract, one can also utilize a futures contract to hedge transaction exposure. These contracts are traded on the exchange and do not have counterparty risks as they are highly regulated. In a future contract, the buyer has an obligation to honour the contractual terms specified for the exchange of foreign currencies at a predetermined exchange rate and date. Future and forward contracts are similar to each other in principle but have differences regarding their flexibility, level of regulation, associated risks and the presence and absence of standardized terms of the contract that remain the same for each counterparty.
  3. Option Contract
    An Option Contract is another method to hedge transaction exposure. This contract gives the right but not the obligation to the investor to buy and sell foreign currency at the specified date & time. The holder of this type of contract must pay a certain amount called the 'premium' for having the right to exercise an options trade, the unfulfillment of which causes the holder to lose the premium amount.
  4. Money Market Hedge

    Hedges using the money market can be used by businesses for whom future market hedges are not available or too expensive, and where a forward market hedge carries too much risk of insolvency. It is called a money market hedge as it involves borrowing or lending in the short-term money market while allowing an organization to make the required exchange of currencies at the current spot rate for its future receivables or payables.

For foreign exchange exposure and risk management, an understanding of how each technique or method can be used to hedge future payables and receivables is important for devising a cost and time effective strategy while meeting the firm's objective. Myforexeye enables organizations to implement the right hedging strategy required to enhance security against transaction exposure through the right tools and correct judgements regarding whether all of the transaction should be hedged or it should be hedged selectively, or none of it should be hedged. 

From the guidance in the utilization of other methods for mitigating forex risks to formulating correct foreign exchange risk management strategies using the traditional hedging techniques, Myforexeyes's Dr. Forex service can provide effective solutions through expert consultation and hedging recommendation. One can avail assistance from experts on a transactional basis via video or phone call and get research-backed forex reports, access to live forex rates and resolution of their forex queries, along with an improved understanding of forex know-hows from our advisory team.  

Conclusion

Myforexeye is committed to providing a resolution to your Forex and trade finance needs and filling the gap of the unmet demands in terms of credit and financial guidance to MSMEs and larger corporates. Through our team of experienced professionals and consultants well versed in the field of forex and trade finance, we provide streamlined forex solutions for one’s convenience and at their disposal. Corroborating our efforts of providing solutions that are effective to companies for realizing their maximum potential are the latest technology and assistance from the veterans of the forex and trade finance industry. It is our objective to aid our clients in making savings and eliminating the aspect of hidden commission fees payable to the bank. Our user-friendly digital platforms - web portal and mobile app, enables one to access the best quotes for all types of forex conversions as well as avail import and export finance and calculate interest costs to make informed decisions. 

Speak to one of our specialists to acquire a detailed understanding of forex solutions offered by Myforexeye. 

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