Page 111 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes 7.3.4 Exposure Netting

Exposure netting involves offsetting exposures in one currency with exposures in the same or
another currency, where exchange rates are expected to move in such a way that losses (gains) on
the first exposed position should be offset by gains (losses) on the second currency exposure.
The assumption underlying exposure netting is that the net gain or loss on the entire exposure
portfolio is what matters, rather than the gain or loss on any individual monetary unit.
The above mentioned methods show how a firm can hedge exchange exposures if it wishes. The
next question therefore is – should a firm try to hedge to start with? Based on literature survey
there is no consensus on whether the a should hedge or not. Some writers argue that transaction
exposure management at the organisational level is not required and that shareholders can
manage the exposure themselves. The various reasons in favour of exposure management at the
corporate level are:

1. Information asymmetry: Management is aware about the firm’s exposure position much
better than shareholders. Thus, management of the firm should manage exchange exposure.
2. Transaction costs: The firm is in a better position to acquire low cost hedges and hence,
transaction costs can be significantly reduced. For individual shareholders, the transactions
costs can be substantial.
3. Default cost: In a corporate hedging, probability of default is significantly lower. This, in
turn, can lead to a better credit rating and lower financing costs.

Self Assessment

Fill in the blanks:
4. A Money Market Hedge involves simultaneous …………………… activities in two different
currencies.
5. Options are used to …………………….
6. Exposure netting involves …………………… in one currency with exposures in the same
or another currency.
7. In a corporate hedging, probability of default is significantly …………………….
8. In a Forward Market Hedge, a company that is long in a foreign currency will
…………………… the foreign currency forward.
9. A company that is short in a foreign currency will …………………… the currency forward.
10. The firm seeking the money market hedge borrows in one currency and ……………………
the proceeds for another currency.

7.4 Risk Management Products

In a survey, Jesswein, Kwok and Folks documented the extent of knowledge and use of foreign
exchange risk management products by US corporations. Based on a survey of Fortune 500 firms,
they found that the traditional forward contract is the most popular product. As shown below,
about 93 per cent of respondents of the survey used forward contracts. This old, traditional
instrument has not been supplemented by recent ‘fancy’ innovations. The next commonly used
instruments were foreign currency swaps (52.6 per cent) and over-the-counter currency options

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