Transaction exposure emerges from the probability of experiencing gains and losses on existing transactions estimated in the firm's home currency per unit shift in exchange rates. On the other hand, translation exposure arises when there is an impact on the consolidated financial statements of a firm resulting from changes in exchange rates during consecutive consolidation dates of the firm.
Transaction exposure is the more important of the two risks to hedge. This is because it impacts cash flows and the firm’s market value directly. Controlling this risk would involve managing and reducing the impact of the fluctuations in the exchange rates in the firm’s transactions. Although managing translation risk is not a high priority in this instance, hedging this exposure reduces the risk perceived by stakeholders. Some methods commonly used to control this exposure include:
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Asset-Liability Management (ALM)
In cases of currency depreciation, multinational firms may decrease assets by decreasing investments to manage this exposure. For expected currency appreciation, firms should increase their investments. An advantage of this hedging method is that it helps firms increase profitability in currency appreciation scenarios by meeting liquidity requirements and maintaining the firm's credit level. This method also controls liabilities in the long-term and ensures optimal asset investment. A challenge of using ALM is that it is a longer-term hedging method. Since it depends on forecasting, some firms may lack readily available datasets.
Derivatives Hedge
This entails speculation about the movement of the foreign exchange rate. This form of hedging could involve using currency forwards. Currency forwards involve exchanging home and foreign currencies on an agreed future date and price. An advantage of using forward contracts is the lack of transaction costs for risk control when using forward contracts. Another crucial advantage is that it delivers a fixed exchange rate at a future date, eliminating the uncertainty accompanying exchange rate fluctuations. A setback of this method is that there is no opportunity to benefit from the shift when the exchange rates shift favorably. Another disadvantage applies to the difficulty in finding counterparty. This depends on the demand for the currencies involved in the forward markets.
