The main feature of a transaction exposure is the ease of identifying its size. Additionally, it has a well-defined time interval associated with it that makes it extremely suitable for hedging with financial instruments.
The most common methods for hedging transaction exposures are −
● Forward Contracts − If a firm has to pay (receive) some fixed amount of foreign currency in the future (a date), it can obtain a contract now that denotes a price by which it can buy (sell) the foreign currency in the future (the date). This removes the uncertainty of future home currency value of the liability (asset) into a certain value.
● Futures Contracts − These are similar to forward contracts in function. Futures contracts are usually exchange traded and they have standardized and limited contract sizes, maturity dates, initial collateral, and several other features. In general, it is not possible to exactly offset the position to fully eliminate the exposure.
● Money Market Hedge − Also called as synthetic forward contract, this method uses the fact that the forward price must be equal to the current spot exchange rate multiplied by the ratio of the given currencies’ riskless returns. It is also a form of financing the foreign currency transaction. It converts the obligation to a domestic-currency payable and removes all exchange risks.
● Options − A foreign currency option is a contract that has an upfront fee, and offers the owner the right, but not an obligation, to trade currencies in a specified quantity, price, and time period.
Note − The major difference between an option and the hedging techniques mentioned above is that an option usually has a nonlinear payoff profile. They permit the removal of downside risk without having to cut off the profit from upside risk.
The decision of choosing one among these different financial techniques should be based on the costs and the penultimate domestic currency cash flows (which is appropriately adjusted for the time value) based upon the prices available to the firm.
