Foreign Exchange Risk Mitigation Techniques/Measuring Foreign Exchange Exposure
Measuring Foreign Exchange Exposure
Transactions in the form of purchase contracts or agreements denominated in a foreign currency but not yet settled create transaction exposure. The fluctuation of the currency will have an impact on the value until the transaction is completed. The value of an unsettled export receivable or an import payable is just one example. There are multiple hedging techniques to help the investor minimize his risk, including:
- forward contracts
- futures contracts
- use of a money market hedge
- contractual risk sharing
- pricing adjustments based on forward rates
- foreign currency accounts
- foreign currency options
The revaluation of all foreign-denominated assets and liabilities often referred to as transfer pricing is usually considered “paper” gains or losses. The conversion of an asset by selling it and converting the proceeds to the local currency would create a realized gain or loss. This form of exposure is created when financial statements are prepared and converted to the local currency of the owner or investor. This form of exposure is considered an indication of potential gains or losses.
The evaluation of foreign governments from an economic standpoint determines whether a translation exposure could be realized. The projected stability of a country, both politically and economically, impacts future cash flows and can adversely impact the profitability of an organization. Strategic planning for operations must include economic exposure.