Hedging Translation Exposure

The above exhibit indicates that there is still enough translation exposure with changes in the exchange rate of the Mexican Peso and the Euro against the U.S. dollar. There are two major methods for controlling this remaining exposure. These methods are: balance sheet hedge and derivatives hedge.

Balance Sheet Hedge

Translation exposure is not purely entity specific; rather, it is only currency specific. A mismatch of net assets and net liabilities creates it. A balance sheet hedge will eliminate this mismatch.

Using the currency Euro as an example, the above exhibit presents the fact that there are €1,826,000 more net exposed assets than liabilities. Now, if the Spanish affiliate, or more probably, the parent firm or the Mexican affiliate, pays €1,826,000 as more liabilities, or reduced assets, in Euros, there would be no translation exposure with respect to the Euro.

A perfect balance sheet hedge will occur in such a case. After this, a change in the Euro / Dollar (€/$) exchange rate would not have any effect on the consolidated balance sheet, as the change in value of the assets would completely offset the change in value of the liabilities.

Derivatives Hedge

According to the corrected translation exposure report shown above, depreciation from €1.1000/$1.00 to €1.1786/$1.00 in the Euro will result in an equity loss of $110,704, which was more when the transaction exposure was not taken into account.

A derivative product, such as a forward contract, can now be used to attempt to hedge this loss. The word “attempt” is used because using a derivatives hedge, in fact, involves speculation about the forex rate changes.


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