Page 108 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 7: Management of Transaction Exposure

contracts denominated in foreign currencies, judicious measurement and management of Notes
transaction exposure has become an important function of international financial management.

7.1 Measurement of Transaction Exposure

Transaction exposure measures gains or losses that arise from the settlement of existing financial
obligation whose terms are stated in a foreign currency. Two steps are involved in measuring
transactions exposure:

1. Determine the projected net amount of currency inflows or outflows in each foreign
currency; and
2. Determine the overall exposure to those currencies.

The first step in transaction exposure is the projection of the consolidated net amount of currency
inflows or outflows for all subsidiaries, classified by currency subsidiary. Subsidiary A may
have net inflows of $6,00,000 while subsidiary B may have net outflows of $7,00,000. The
consolidated net inflows here would be – $1,00,000. If the other currency depreciates, subsidiary
A will be adversely affected while subsidiary B will be favourably affected. The net effect of the
dollars depreciation on the MNC is minor since an offsetting effect takes place. It could have
been substantial if most subsidiaries of the MNC had future inflows of US dollars. Thus, while
assessing the MNCs exposure, it is advisable, as a first step, to determine the MNC’s overall
position in each currency.
However, in case of a non-centralised approach each subsidiary acts independently and assesses
and manages its individual exposure to exchange rate risk. Such an approach gives important
responsibilities to each subsidiary to plan out its future strategy in accordance with currency
movements.

Example: Consider a US based MNC. All inflows and outflows for each currency are
combined to determine the “net” position in that currency. The MNC then uses the range of
possible exchange rates to the number of units of each currency to determine a possible range of
its local currency inflows or outflows related to each foreign currency.
Currency Net Inflow or Outflow Range of Range of possible net inflow or
expected outflow in US dollars (based on
exchange rates range of possible exchange rates)
French francs FFr 20,000,000 (inflow) $ .12 to $ .14 $ 2,400,000 to $ 2,800,000 (inflow)
Swiss francs SFr 10,000,000 (outflow) $ .60 to $.64 $ 6,000,000 to $ 6,400,000 (outflow)
German francs CDM DM 5,000,000 (outflow) $ .50 to $.53 $ 2,500,000 to $ 2,650,000 (outflow)
Canadian dollars C$ 8,000,000 (inflow) $ .85 to $ .88 $6,800,000 to $ 7,040,000 (inflow)

The first row shows that the MNC has a net inflow of FFr 20,000,000. Based on an expected
exchange rate ranging from $.12 to $.14, the range of possible net inflows are $2,400,000 to
$2,800,000 (20,000,000 × .12 = $2,400,000 and 20,000,000 × .14 = $2,800,000). Similarly, the range of
possible net inflow/outflow for each currency in US dollars can be calculated. The respective
calculations are shown in the last column.

Did u know? The important point is that a firm’s transaction exposure in any foreign
currency is not only based on the size of its open position but also on the range of possible
exchange rates that are expected in each currency.

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