1).What factors affect a firm`s degree of transaction exposure in aparticular currency? For each factor, explain the desirablecharacteristics that would reduce transaction exposure.
Transactionexposure describes the experience of a multinational corporation’scontractual transactions to the exchange rate movements. The twofactors that impact an entity’s transaction exposure are currencyvariability and currency correlation (Brigham et al., 2013).Currencies tend to have different variability, which may be measuredthrough standard deviation. In terms of currency variability, itimplies that a currency may have stability or high inconsistency inthe future. In other words, currency variability can be perceived ashow a currency fluctuates. In the case of currency variability, thedesirable characteristic that would mitigate the transaction exposureis low level of currency variability. This would be desirable since alow level of variability would imply that a currency does not highlyfluctuate in relation to another currency.
Alternatively,currency correlation helps in understanding whether pair ofcurrencies tends to move in the same, random, or opposite directionover a given period of time. This concept comes into play since thereis no single currency pair that can be isolated, but has to move in acertain direction (Madura, 2012). When it comes to the idea ofcurrency correlation, the correlation coefficient has to range amid-1 and +1. In case two currencies move 100% in the same direction,then the correlation coefficient of the two currencies is +1.Alternatively, when a currency pair moves in the opposites, then thecorrelation coefficient is -1. However, in case two currencies areindependent, then the two have a correlation coefficient of zero. Thedesirable characteristic, which would reduce transaction exposure forcurrency correlation is low level of correlation for currencies thatare net inflows, but high levels where one currency is a future netinflow and the other future net outflow (Madura, 2012).
2).Explain how a U.S. corporation could hedge net receivables inMalaysian ringgit with a forward contract.
Currencyhedging describes the act of entering into a financial contract so asto protect against expected, unexpected, or anticipated changes inthe exchange rate of currency (Choudhry, 2013). The hedging processis utilized by businesses and financial investors in an attempt toeliminate the risks that they may encounter when conducting businessacross border. The process can be accomplished through buying orbooking various types of contracts, which are intended to attainspecific goals. The objectives to be achieved are usually grounded onthe risk level the customer is exposed to as well as allowing peopleto lock in future rates without impacting their liquidity to agreater extent (Choudhry, 2013).
Aforward contract is an agreement that is customized amid two partiesto sell or purchase an asset at a given price on a future date. Thecontract may be customized to any merchandise, amount, or deliverydate (Rhoads, 2011). In case a U.S. based corporation desired tohedge net receivables in ringgit through a forward contract, thenthis would be realized by the corporation negotiating with a bankinginstitution to offer the bank ringgit in exchange for the dollarcurrency at a given exchange rate, which would be at a specifiedfuture date. In case the bank agrees to provide ringgit at thespecified rate, in the future, then the contract would become a donedeal.
Brigham,Eugene F, and Joel F. Houston. Fundamentalsof Financial Management.Mason, Ohio: South-Western, 2013. Print.
Choudhry,M. (2013). Theprinciples of banking: A guide to asset-liability and liquiditymanagement.Chichester: Wiley.
Madura,J. (2012). Internationalfinancial management.Mason, OH: South-Western, Cengage Learning.
Rhoads,R. (2011). TradingVIX derivatives: Trading and hedging strategies using VIX futures,options, and exchange-traded notes.Hoboken, N.J: Wiley.