Due to globalization, companies may have exposure to foreign exchange risk, as u
ID: 2712450 • Letter: D
Question
Due to globalization, companies may have exposure to foreign exchange risk, as unexpected change of exchange rate may affect the settlement of contracts and firm value. Answer the following questions related to foreign currency exposure.
Questions:
(1)List two major differences between transaction exposure and economic exposure.
(2)List two reasons why operational hedging is better than financial hedging in the management of economic exposure.
(3)True or false? “If a company’s revenue and costs/ expenses are in home currency, it does not have any transaction exposure or economic exposure.” Explain.
Explanation / Answer
Economic exposure is also known as operating exposure as it arises due to fluctuations in the company’s future cash flows. Whereas, the transaction exposure is the effect of change in exchange rate on the outstanding obligations.
Differences are as follows:
Transaction exposure is related with short-term cash flows whereas economic exposure is related with long-term future cash flows.
The transaction exposure can be measured for given exchange rates but economic exposure cannot be measured as the future cash flows are conjecture.