Part1: Management of Transaction Exposure in detail |English| #International Finance
Summary
TLDRThis video educates viewers on managing Foreign Exchange exposures, focusing on transaction exposure. It explains how fluctuating exchange rates impact international business transactions and introduces three types of exposure: transactional, economic, and translation. The video delves into hedging strategies like forward market hedges, money market hedges, and option market hedges, and discusses techniques such as currency risk sharing, leading and lagging, and exposure netting to mitigate risks.
Takeaways
- π International business expansion introduces foreign exchange risks due to fluctuating exchange rates.
- πΌ Transaction exposure arises from international transactions and the risk of unexpected exchange rate changes.
- π΅ Economic exposure affects the overall value of a firm due to unanticipated changes in foreign exchange rates.
- π Translation exposure occurs when consolidating financial statements of subsidiaries operating in different currencies.
- π The risk of exchange rate fluctuation increases with the time gap between agreement and settlement.
- π Forward Market Hedges fix the exchange rate for future transactions, mitigating the risk of rate changes.
- πΉ Money Market Hedges involve borrowing in one currency, converting it to another, and investing in money market instruments to hedge against currency risk.
- π Option Market Hedges provide the right, but not the obligation, to buy or sell currency at a specified rate, offering flexibility.
- π Swaps allow two parties to exchange principal and interest payments in different currencies to manage currency and interest rate risks.
- π€ Currency risk sharing is an agreement between two parties to fix an exchange rate in advance to reduce exposure.
- πββοΈ Leading and lagging strategies anticipate future events to manage cash flows and timing of transactions to mitigate risk.
- π Exposure netting offsets gains from imports against losses from exports, or vice versa, to balance out currency risks.
Q & A
What is the primary risk a business encounters when it expands into international markets?
-The primary risk a business encounters when it expands into international markets is the fluctuating exchange rate.
How does the fluctuation in exchange rates affect a business?
-Fluctuation in exchange rates affects the settlement of contracts, cash flows, and the firm's valuation.
What is transaction exposure in the context of foreign exchange?
-Transaction exposure refers to the risk of unexpected exchange rate changes when a business engages in international transactions.
What are the three types of foreign exchange exposures mentioned in the script?
-The three types of foreign exchange exposures mentioned are transaction exposure, economic exposure, and translation exposure.
How does the time gap between agreement and settlement affect the risk of transaction exposure?
-The larger the time gap between agreement and settlement, the greater the risk involved in exchange rate fluctuation.
What is a forward market hedge and how does it help in managing transaction exposure?
-A forward market hedge is a contract that fixes the exchange rate for a future transaction, helping to mitigate the risk of exchange rate fluctuations.
What is the difference between a forward contract and an option contract in the context of hedging?
-In a forward contract, there is an obligation to buy or sell at the agreed rate on a specific date, whereas an option contract gives the right, but not the obligation, to buy or sell at a specified rate on or before a specified date.
How does a money market hedge work in managing foreign exchange risk?
-A money market hedge involves borrowing in one currency, converting it to another, and investing in money market instruments to offset potential gains or losses from exchange rate fluctuations.
What is a swap in the context of foreign exchange risk management?
-A swap is an agreement between two parties to exchange principal and interest payments in different currencies, often used to manage currency risk or to obtain better interest rates.
What are the various techniques of hedging transaction exposure mentioned in the script?
-The various techniques of hedging transaction exposure mentioned are currency risk sharing, lead and lag strategy, and exposure netting.
What is the lead and lag strategy in managing foreign exchange risk?
-The lead and lag strategy involves making financial decisions based on predictions of future events (leading) or based on past experiences (lagging) to manage foreign exchange risk.
Outlines
π Understanding Foreign Exchange Exposures
The speaker introduces the topic of managing Foreign Exchange exposures, focusing on transaction exposure. They explain how businesses face fluctuating exchange rates when they expand into international markets, which affects cash flows and firm valuation. An example is given where an Indian company buys machinery from the US, and the exchange rate changes from 76 INR to 1 USD in June to 85 INR to 1 USD in September. The speaker outlines three types of exposure: transaction, economic, and translation. Transaction exposure relates to international transactions and the risk of unexpected exchange rate changes. Economic exposure affects the entire firm's value due to such changes, while translation exposure pertains to the impact on consolidated financial statements when converting from local currencies to the reporting currency.
πΌ Managing Transaction Exposure
The speaker delves into the concept of transaction exposure, emphasizing that it is short-term and related to the time gap between agreement and settlement. The longer the gap, the higher the risk of exchange rate fluctuation. They introduce various hedging techniques to mitigate transaction exposure: financial contracts like forward contracts, money market options, and swaps; currency risk sharing; lead and lag strategy; and exposure netting. Forward Market Hedge is explained as a way to fix the exchange rate at the time of agreement, protecting against future fluctuations. The money market hedge is illustrated using an example of a US firm purchasing British pounds and investing in British treasury bills to hedge against currency risk.
π Exploring Advanced Hedging Techniques
The speaker continues by explaining the option Market hedge, which gives the buyer the right, but not the obligation, to buy or sell a currency at a specified rate before a certain date. This is contrasted with forward contracts, which are obligatory. The concept of swaps is introduced, where two parties exchange principal amounts in different currencies to benefit from different interest rates. Currency risk sharing is described as a strategy where two firms agree on an exchange rate in advance. The lead and lag strategy involves making financial decisions based on predictions of future events (leading) or past experiences (lagging). Exposure netting is also discussed, where the gains from imports are offset by losses in exports, or vice versa, to balance out currency risks.
π Wrapping Up the Discussion on Hedging
In the concluding paragraph, the speaker summarizes the discussion on hedging techniques and encourages viewers to like, share, and subscribe if they found the content helpful. The speaker hopes that the audience has gained a better understanding of managing foreign exchange risks through various hedging strategies.
Mindmap
Keywords
π‘Foreign Exchange Exposure
π‘Transaction Exposure
π‘Economic Exposure
π‘Translation Exposure
π‘Hedging
π‘Forward Market Hedge
π‘Money Market Hedge
π‘Option Market Hedge
π‘Swap
π‘Currency Risk Sharing
π‘Leading and Lagging
π‘Exposure Netting
Highlights
Introduction to Foreign Exchange Exposure management
Explanation of transaction exposure and its impact on international business
Example illustrating the fluctuation of exchange rates and its effect on contracts
Types of exposure: transaction, economic, and translation
Detailed discussion on transaction exposure
Importance of managing exchange rate fluctuations for international contracts
The concept of economic exposure affecting the entire firm's value
Translation exposure in the context of consolidated financial statements
Risk associated with the time gap between agreement and settlement in foreign exchange
Various hedging techniques for transaction exposure
Forward Market Hedge as a method to mitigate transaction exposure
Money Market Hedge using treasury bills to manage currency risk
Option Market Hedge providing flexibility in currency transactions
Swap Market Hedge for exchanging principal and interest rates between currencies
Currency risk sharing as a strategy between firms
Leading and lagging strategy to predict and respond to future currency movements
Exposure netting to balance gains and losses from multiple transactions
Conclusion and call to action for viewers to engage with the content
Transcripts
hey welcome to my channel guys I hope
you are doing well and in today's video
we will be covering about management of
Foreign Exchange exposures in this we
will be covering about the types of
exposure and among these exposure is the
transaction exposure we'll be learning
about the management or the transaction
exposure in detail for in today's
lecture right so stay tuned
so let's begin with uh we can see that
whenever the business expand it goes
into the international market right so
whenever the business goes into
International Market the very first risk
that it encounters is the fluctuating
exchange rate right what are the
exchange rate say in Indian currency in
Indian Rupee to
US Dollars it keeps on fluctuating every
day so this is the exchange rate that
keeps on fluctuating so this exchange
rate affects the settlement of the
contract the cash flows that means
inflows and outflow of the cash to your
country and to your firm as well and the
firm's valuation right will understand
this within an example also
let's see about the example say an
Indian company that purchased from us
uh a Machinery worth rupees 10 000 USD
it went into a contract in the month of
June and in the month of June the
exchange rate was rupees 76 per US
dollars right
however the terms of payment was due in
the month of September where the
exchange rate that is Indian rupee to US
dollar went to rupees 85 per US dollar
so you can see that when the company the
Indian company contracted that on that
day the exchange rate was 76 rupees per
US dollar however when the payment was
made it went to 85 rupees per US dollar
so this fluctuation is known as the
fluctuation or the risk of Foreign
Exchange so whenever the company goes
International it faces the fluctuating
foreign exchange this is why we need to
manage it we need to mitigate such risk
and such exposures right
so here are the types of exposure We
have basically three types of exposure
first is it transaction then economic
and translation exposure let's
understand this one by one first is the
transaction exposure now what is
transaction exposure simply I say the
transaction means to buy or sell
something right whenever I buy or sell
say any goods or services I go into
transaction so whenever I go into
transaction that is international
transaction so there is a risk of
unexpected exchange rate changes simple
right
next is your economic exposure over here
the extent is the whole value of the
firm is being affected by unanticipated
change in the foreign exchange
understood first was only for your
transaction one transaction okay
economic is for the entire firm and last
is the translation exposure translation
exposure is done for the Consolidated
financial statement that are being
affected by the change in the exchange
rates now see supposedly there is a firm
there is a headquarter that is U.S it is
a holding company over here is in U.S it
is operating in various countries I am
taking over here in example say it is
operating in India okay it is operating
in Africa
and one more country say in UK okay so
oh sorry over here it is UK so
headquarter is in U.S it has many of its
subsidiaries say in India Africa UK so
on and so forth over here the Indian
firm is will be operating in Indian
currency African firm the subsidiary
will be operating in African currency
and the UK company will be operating in
UK currency so when the financial
statements are being compiled say in the
Indian form it will be an Indian
currency in the Africa when the
financial statements are being completed
it will be in African currency and
similarly for the UK so when all the
subsidiaries combine the financial
statement with the headquarter that is
in U.S this has to be translated these
domestic currencies need to be
translated to the US dollar that is the
holding company so this changes or this
fluctuation in the currencies of
subsidiary and the holding is known as
the translation exposure I hope you guys
have understood and in case of any
queries please comment in the comment
section I will surely reply to you guys
so in today's lecture we'll be dealing
with the transaction exposure in detail
as I have already explained to you that
there is a fluctuation in the exchange
rate right that is the cross-country
contract
okay and we fix the specific amount of
money and quantity in advance this is
also known as the short-term economic
exposure
now there is also one thing that you
need to note over here is larger is the
time gap between agreement and the
settlement larger will be the risk
involved in the exchange rate
fluctuation how supposedly there is a
gap between say agreement was made in
the month of April right
and the transaction or the settlement is
being done in the month of June
right so how many months are there
between these agreement and the
settlement April May and June that means
three months were there however if I say
the agreement was made in the month of
April but it was settled in the month of
December so how many months over here
over here nine months are there so where
will be the risk more
in the second one because the time frame
is more when the time keeps on
increasing there is a risk involved the
risk involved in the exchange rate keeps
on increasing right
so let's understand about the various
hedging transaction exposure what is the
meaning of hedging that means to
mitigate or to protect or to minimize
the transaction exposures so these can
be done through two methods first is the
financial contracts contracts can be the
forward money market options or the
snaps whereas various techniques can
also be used first is the currency risk
sharing then is the lead and lag
strategy and last one is the exposure
netting so let's study this one by one
first is the forward Market Hedge
now what are forward Market hedges
today I am sitting over here and I
contract with any of the US forms right
the agreement is held on what does the
day-to-day say
22nd of September I went into an
agreement that I will buy a Machinery of
say rupees 10 000.
from you but the payment I will make
after two months that means in November
I will be making a payment so what do I
do I fix this rupees I say I will pay
you 10 000 only but after two months
this 10 000 might
this 10 000 might increase or decrease
in future after say two months it will
fluctuate the currency is the foreign
currencies keeps on fluctuating so this
10 000 might increase or decrease so
today if I fix at 10 000 I will pay only
10 000 in the month of November no
matter if this 10 000 goes up to say 12
000 or 13 000 or whatever
however if supposedly it goes
to nine thousand
then still I will have to pay 10 000
only because I have went into an
agreement that I will pay 10 000 as a
buyer
next is the money market hedge now how
this works is that I've taken an example
say U.S firm is operating and it
purchase something from sale UK in
British pound it purchases something in
British Pounds so what it does is it
borrows in US Dollars it borrows certain
loan and converts this into the pounds
and then it invests that money that it
has been con that it has converted into
pounds into the British treasury bill
that is a money market instrument any of
the money market instrument it can go
and invest and then the final whatever
is a gain or loss out of that the import
will bill will be paid by the firm right
so what the firm does it it
firstly takes a loan in the home
currency
okay then it converts it into the other
other countries currency
and then finally it invests in the money
market instruments and whatever is the
gain or loss
the resultant is being
um used to make the payment to the uh
country right the exporters
next is the option Market hedge now what
is the option Market hedge it is simply
a contract where the buyer has the right
but not the obligation
right buyer has the right but not the
obligation to buy or sell a certain
currency at a certain specified exchange
rate on or before a specified date guys
I have already discussed with you about
the forward market right over that I
told you that I have fixed certain
rupees say 10 000 I fixed that amount I
as a buyer had to make a payment of 10
000 whether there was increase or
decrease there was an obligation however
in option Market you do not have any
obligation rather you have the right
so the example let's continue the
example so over here that if I fix that
10 000 and say after two months it
decreases to 9000.
I might not be interested to buy why
should I give 10 000 instead of nine
thousand I will not exercise this right
however if this price goes up to say 12
000 then I will exercise and buy at the
weight 10 000. that was fixed in the
contract this is known as the option the
simply the difference between the
forward and the option Market is that
there is no obligation in the option
Market first second is that I can buy on
or before any specified date right in
the forward there was a specific date
however in the for option Market this
you can buy any time before the specific
date or on the specific date itself
right
okay next is the swap now what is this
meaning of swap simply exchange right
you have something I have something we
swap it right uh it should benefit both
of us I've taken one of the examples
over here I'll explain this you with the
help of an example
um over here we have two forms one is us
and one is the African foam now U.S form
has an option it can easily get uh U.S
Loan in US Dollars it can get a U.S loan
at the rate of six percent however it
wants to invest in Africa but in the
African currency that is in Rand it the
loan is available at the rate of nine
percent
right another firm that is African firm
that wants that can borrow in US dollar
at the rate of eight percent however
it has also an option of uh that is
available at the rate of 11 in US dollar
so what they do is that they exchange
their rate of interest they'll have the
principal and they will uh interchange
the they will swap the interest rate so
that both of the firms benefits from
such a transaction right
so let's understand the meaning the
transaction between two parties we've
understood
exchange an equivalent amount of money
with each other but in different
currencies first
and these are primarily used for the
potential risk associated with
fluctuations in currency exchange rates
or to obtain lower interest rates on the
loans in the foreign currencies right I
hope you've understood the meaning of
swap markets
now we are going to start about the
techniques various techniques of hedging
first is the currency risk sharing over
here what do we do if supposedly there
are two
firms A and B firms are there they will
fix a certain currencies exchange rate
they will set a certain currency in
advance say we say to rupees
70 per US Dollars it has already been
set so this is the currency risk sharing
between A and B say two firms right
operating internationally
next is the leading and lagging what do
you understand by the term leading that
means in advance taking forward steps
and lagging is to go back so we take
into consideration whatever is going to
happen in future supposedly when there
was a Russian Ukraine war what people
were expecting over there that oil
prices might rise so that is leading
that means I am taking assumptions or I
am predicting that might happen in
future right
however for lagging I take into
consideration my past experience from
various Wars that happened we make
certain assumptions and we predicted and
we went for the forecast that this might
happen in future right so this is your
leading and lagging
last but not the least your last
technique is your exposure netting so
over here what do we do there are number
of transactions for imports and exports
right
so netting is being done that means
total total is being done so if the
Importer keeps on gaining every every
time the Importer keeps on getting say
positive return it will be offset by the
his laws in exports and vice versa so
this is your total netting that means
your profits or the losses from Imports
that is being equalized from your
profits or losses from your exports that
is it for today guys I hope you have
liked and learned something if yes then
please do like share and subscribe to my
channel thank you and have a nice day
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