Abstract
Transaction exposure refers to the potential to gain or loose in a contracted for near term cash flows such as foreign currency accounts receivable and accounts payable among other debts (Moffett, Stonehill, and Eiteman 220). The exposure is caused by foreign exchange rate variations in the amounts that are owing to the MNEs or amounts that the MNEs owe other entities. Literally, transaction exposure refers to the variations in the home currency value of cash flows that have already been contracted for.
Methods of reducing transaction exposure
The main strategy for managing operating exposure at the strategic level is for the management of the MNE to identify disequilibrium in the optimal conditions and to be strategically positioned to act in the most appropriate manner. This can be achieved through:
Diversification of operations: the global diversification positions a firm in a suitable position to respond quickly in cases of transaction exposure. A well diversified firm is able to shift the sourcing, production, and sales from one currency to another in order to take advantage of the variations in the post devaluation economic conditions.
Diversifying financing: unanticipated variations in the foreign exchange rates lead to variations in the costs of various components of capital; more so the cost of debt in one market in comparison to other markets. If a country has well diversified its sources of finance; i.e. the firm is well established in several capital markets, it can shift quickly within markets to take advantage of temporary variations in currency through the Fisher effect. This is done by altering the currencies where the borrowing was made.
Operating Exposure
Operating exposure refers to the potential of a change in the value of an MNE. It is often seen as the variation of the present value of all the future cash flows of an MNE as a result of unexpected variations in the foreign exchange rates (Moffett, Stonehill, and Eiteman 308). Literally, it refers to the long-term variations in the value of a company as a result of the variations in the foreign exchange rates. The future cash flows are expected by the MNE in the normal operations of the company; however, they have not yet been contracted for by the company.
Methods of reducing Operating exposure
Operating and transaction exposures can be managed partially by implementing operating and financing policies that counteract the anticipated foreign exchange exposures. There are four main strategies:
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Matching currency cash flows: the main idea under this strategy is to create financial and operating foreign currency cash inflows that are equal to the foreign currency outflows. Regularly, debt is acquired in the same foreign currency that the cash flows will be received.
Risk-sharing arrangements: this entails the contracting parties entering into agreements in such a way the parties share the loss or gains that result from the variations in the foreign exchange rates.
Back loans: two contracting firms lend each other of their home currency under the agreement that the companies shall refund each company the same amount at a later date. The back-to-back loan appears as both an asset and liability in the balance sheet of the two companies.
Currency swap: under this strategy, each company gives and receives an equivalent amount of foreign currency of the participant’s currency. There is no liability or asset that is recorded in the financial statements. The swap enables the participants to utilize foreign currency operating inflows to wind down the swap at a later date.
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Translation Exposure
Translation Exposure refers to the possibility of variation in equity i.e. common stock, equity reserves and retained earnings of a multinational company consolidated statement of financial position as a result of variations (whether anticipated or unanticipated) in the foreign exchange rates (Moffett, Stonehill, and Eiteman 362). Thus, translation exposure is not categorized under the cash flow variations; rather it results from the consolidation of the subsidiary and affiliated companies to the single financial statements of the parent company. Therefore, translation exposure is more of book gains or losses from the variations in the exchange rates.
Methods of reducing Translation exposure
Balance sheet hedge: this is the main technique for minimizing translation exposure. The technique requires an equivalent amount of the exposed foreign currency assets and liabilities on the consolidated financial statements of a company. This minimizes the translation exposure to zero.
Works cited
Moffett, Michael, H. Stonehill, Arthur, I. and Eiteman David K. Fundamentals of Multinational Finance. 3rd Ed. New York, NY: Addison Wesley, 2008. Print.