Transaction risk arises from executed contracts resulting in Forex payables or receivables in the future. The domestic currency value of these payables or receivables at current exchange rate and at future exchange rate is expected to be at variance, resulting in transaction risk. The forex transaction risk can be hedged using internal strategies. Internal strategies refer to strategies that are internal to the firm and its affiliates. These are “home’ arrangements. The counter party to the transactions may be involved. But third parties are never involved.
The different internal strategies used for managing forex transaction risk are:
- Risk Netting: This strategy involves matching forex receivables in a currency with forex payables in that currency. Both currency and time matching are needed. Suppose an US firm has Yen 10 mn receivable from and Yen 7 mn payable to same counter party, both having 90 days to mature. These two transactions can be netted and the exposure reduces to Yen 3 mn. There are bilateral and multilateral netting. The above one is bilateral netting. Multilateral netting involves a firm having forex payables with a party netting the same against forex receivable due from another party. Netting in general involves, counter adjusting a long position in a currency to a short position in the same currency.
- Risk Shifting: Let General Electric of US supply turbine blades to Lufthansa of Germany valued at Euro 25 mn. The payment is due in 90 days. Current spot is Euro 1 = USD 1.1. GE fears Euro to depreciate two months hence and that is dollar realization upon conversion of the Euro receivable will be must smaller than the USD 27.5 mn now possible. So, GE wants to shift the foreign exchange exposure to Lufthansa, this is possible if Lufthansa agrees to invoicing the deal in US Dollar, in which case the Forex risk is shifted to Lufthansa. Lufthansa has to manage the risk by itself which has now assumed the risk.
- Risk Sharing: Suppose IBM and British airways are involved in a transaction. IBM is supplying flight management system to British airways, valued at $ 160 mn payable 3 months from now. IBM and British airways are agreeing to share exchange risk. Customized hedge is brought into the transaction whereby risk of exchange rate fluctuation beyond certain level, either way, is mutually shared. Since IBM invoices in USD, fluctuation in rate upto certain range, either way, is to be borne by British airways. This range, around a base rate, say $1 = £ 0.75 is called neutral range. At the base rate, the £ value of the transaction is 120 mn dollar. Let the neutral range be 1$ = 0.72 to 0.78 £. That is, if $ depreciates upto £ 0.72/$ or appreciates upto 0.78 the British airways takes up the risk on its part. Within the neutral zone, British airways will pay the original dollar value of the contract namely 160 mn $ and its £ cost will vary between £ ($ 160 mn x 0.72) and £ ($ 160 mn x 0.78) or between £ 115.2 mn and £ 124.8 mn. If the £ – $ rate breaches the neutral zone, the risk is to be jointly share. Suppose, £ depreciates to 0.8, then the exchange loss above the upper bound is equally shared. So, the adjusted rate comes to £ 0.75 + (0.5/2) = £ 0.775/$. So the value of contract is arrived at as follows: Base rate value of the contract in £/Effective adjusted rate is equal to £ 120 mn /0.775= $ 154.8387 mn. If the £ appreciates beyond the lower bound, to say £ 0.68/$ then British airways cannot get the full benefit of £’s appreciation. The gain beyond £ 0.72/$ is shared with IBM and the adjusted rate comes to £ 0.68 + 0.04/2 = £ 0.70/$. The adjusted dollar value of the contract is = £ 120 mn / 0.7 = $ 171.4286 mn.
- Risk Off-Setting: Off-setting of risk means exposure in one currency is adjusted against exposure in another currency. Off-setting is different from netting, where exposure in one currency only is involved, when export and import are in the same currency area and netted against each other. In contrast, off-setting involves exposures in two different currencies. Suppose a Singapore Firm exports to Yen area and also to US dollar area. Since yen and dollar move in opposite direction, exchange loss (gain) in yen realization is off-set to an extent by exchange gain (loss) in dollar realization. Here currencies are opposite to one another, but transactions are of the same type. Consider another case. Here currencies are parallel. That is, they sink (i.e. depreciate against a third currency) or sail (i.e. appreciation) together. $ and ¥ are parallel. Say, GM of US exports to Germany and imports from Japan. The transactions are opposite in nature. If there is exchange gain in the exports, there will be exchange loss in the imports and vice-versa.
- Pricing: To cover transaction risk, price escalation may be adopted as a measure of dealing with Forex exposure. If exchange loss is expected a marginal hike in price can be done to take care of the loss. But competitive factors need to be considered.
Alternatively choice of currency of invoice may be a Forex risk management tool. Invoice, if made in stronger currencies, the exporter can minimize exchange loss. Invoice, if made in weaker currencies, the importer can minimize exchange loss.
Credit: International Finance-MGU MBA