Part1: Management of Transaction Exposure in detail |English| #International Finance

Summary

This 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

• 🌐 International business expansion introduces foreign exchange risks due to fluctuating exchange rates.
• 💼 Transaction exposure arises from international transactions and the risk of unexpected exchange rate changes.
• 💵 Economic exposure affects the overall value of a firm due to unanticipated changes in foreign exchange rates.
• 📈 Translation exposure occurs when consolidating financial statements of subsidiaries operating in different currencies.
• 📉 The risk of exchange rate fluctuation increases with the time gap between agreement and settlement.
• 🔄 Forward Market Hedges fix the exchange rate for future transactions, mitigating the risk of rate changes.
• 💹 Money Market Hedges involve borrowing in one currency, converting it to another, and investing in money market instruments to hedge against currency risk.
• 📊 Option Market Hedges provide the right, but not the obligation, to buy or sell currency at a specified rate, offering flexibility.
• 🔄 Swaps allow two parties to exchange principal and interest payments in different currencies to manage currency and interest rate risks.
• 🤝 Currency risk sharing is an agreement between two parties to fix an exchange rate in advance to reduce exposure.
• 🏃‍♂️ Leading and lagging strategies anticipate future events to manage cash flows and timing of transactions to mitigate risk.
• 🔄 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

00:00

🌐 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.

05:01

💼 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.

10:04

📈 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.

15:04

📊 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.

Keywords

💡Foreign Exchange Exposure

Foreign Exchange Exposure refers to the risk that arises from fluctuations in foreign currency exchange rates. In the video, it is discussed as the primary risk encountered by businesses when they expand into international markets. The script mentions that the exchange rate between the Indian Rupee and the US Dollar fluctuates, which can affect the settlement of contracts and the firm's valuation.

💡Transaction Exposure

Transaction Exposure is a type of foreign exchange exposure that deals with the risk of unexpected changes in exchange rates during international transactions. The video uses the example of an Indian company that agreed to purchase machinery worth $10,000 USD in June when the exchange rate was 76 INR per USD, but had to pay 85 INR per USD in September, illustrating how transaction exposure can impact a company's costs.

💡Economic Exposure

Economic Exposure is the impact of unanticipated changes in foreign exchange rates on the overall value of a firm. Unlike transaction exposure, which focuses on individual transactions, economic exposure considers the broader financial implications for the entire firm. The video script does not provide a specific example but implies that economic exposure is a more comprehensive risk assessment.

💡Translation Exposure

Translation Exposure occurs when a firm has subsidiaries in different countries and must consolidate their financial statements into a single currency. The video explains that when subsidiaries operate in different currencies, fluctuations in exchange rates can affect the translated values of their financial statements. An example given is a U.S. holding company with subsidiaries in India, Africa, and the UK, where local currencies must be translated into USD.

💡Hedging

Hedging, in the context of the video, refers to strategies used to mitigate or minimize transaction exposure. It involves techniques such as forward contracts, money market hedges, and options to protect against adverse currency movements. The video script provides examples like fixing the exchange rate for a future payment to manage the risk associated with currency fluctuations.

💡Forward Market Hedge

A Forward Market Hedge is a financial contract that locks in an exchange rate for a future transaction. The video script explains this concept by stating that if a company agrees to pay a fixed amount in a foreign currency at a future date, it can enter into a forward contract to protect against unfavorable exchange rate changes by fixing the rate today.

💡Money Market Hedge

A Money Market Hedge involves borrowing in one currency, converting it to another, and investing in money market instruments to hedge against currency risk. The video provides an example of a U.S. firm purchasing British pounds and investing in British treasury bills to hedge against future currency fluctuations.

💡Option Market Hedge

An Option Market Hedge gives the buyer the right, but not the obligation, to buy or sell a currency at a specified rate before a certain date. The video contrasts this with a forward contract, explaining that with options, the buyer can choose not to exercise the right if the market rate becomes more favorable, offering more flexibility.

💡Swap

A Swap, as discussed in the video, is an agreement between two parties to exchange interest rates or principal amounts in different currencies. The script uses an example of a U.S. firm and an African firm swapping interest rates to benefit from more favorable rates in their respective currencies.

💡Currency Risk Sharing

Currency Risk Sharing is a technique where two firms agree on a fixed exchange rate for transactions between them. This approach is highlighted in the video as a way to reduce the uncertainty of future exchange rate movements and to provide stability in international trade.

💡Leading and Lagging

Leading and Lagging is a hedging technique that involves timing transactions to take advantage of expected future exchange rate movements. The video script describes leading as anticipating future events, like predicting oil price increases due to geopolitical tensions, and lagging as basing decisions on past experiences and historical trends.

💡Exposure Netting

Exposure Netting is a strategy that involves offsetting gains from one transaction against losses from another to reduce overall exposure to currency fluctuations. The video explains that a company with frequent imports and exports can use netting to balance out currency gains and losses, thus minimizing risk.

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