The growth of multinational businesses has resulted in the emergence of global corporations. These large corporations have international operations and are exposed to foreign exchange risks. The foreign exchange risks are categorised into three types: transaction risk, translation risk and economic risk.
Transaction risk is the foreign exchange risk of one particular transaction or a set of transactions. The economic risks are transaction risks that are inherent to a business and will continue to exist, while translation risk is the loss in value of assets or equity due to a translation from one currency to another.
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Hedge transaction risk by buying or selling foreign exchange in the currency forwards market. A currency forward involves buying or selling a specified currency at a future time, but the price for the exchange rate is fixed today.
Suppose a company based in the United States sold products worth 10 million pounds to a company in the United Kingdom, and expects to receive the amount three months from now. It may enter into a forward contract today, to exchange the cash inflow in pounds for U.S. dollars three months from now.
The price is fixed today at the current forward rate that will be different from the market rate today. This eliminates the uncertainty in cash flows and the foreign exchange risk.
Sell products or services based on local currency. For example, if the company above sold its products to the company in the United Kingdom based on U.S. dollars, than the transaction risk is automatically eliminated and transferred to the purchasing company.
Transfer the economic risk component of the foreign exchange exposure to the end user by rebranding your product or services in a way that foreign exposure becomes irrelevant to the firm.
The wine manufacturers from Argentina have a major economic exposure as they sell a majority of their wine to customers in the United States. Argentinian wine sells at a price range below £6, as it is considered a lower-quality wine.
However, if the Argentinian currency depreciates slightly, the wine manufacturers will not be able to command this price and lose a major portion of their clientele. This issue was solved by certain wine manufacturers by rebranding their product and enhancing their acceptability in the United States market.
Invest in markets that are expected to perform well and whose currency is expected to appreciate. An appreciation of currency in markets where your business operates implies a translation gain on foreign exchange as opposed to a loss. This will reduce foreign exchange risk exposure in your business operations.
Diversify your operations extensively, so that foreign exchange losses in some markets are offset by foreign exchange gains in other markets. This strategy is often used as a natural hedge by certain businesses, in order to mitigate the foreign exchange exposure.
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