Discuss which exposure might be viewed as the most important to manage
Discuss which exposure might be viewed as the most important to manage. It is a given that transaction exposure can and must be managed to a certain degree. As we have discussed before, forward contracts can hedge against foreign exchange risk and exposure. But at the same time, these exposures and risks can only be managed and diversified away to a certain finite degree. When a firm or investor’s main goal is to trade in foreign exchange, the foreign exchange risk would be considered ultimately undiversifiable in a sense. So while this is the name of the game and it would be excellent to speculate and hedge correctly 100% of the time, it is not likely possible. Nevertheless, depending on their risk management style and ultimate investment goals (risk tolerance, business risk, aggressiveness/conservativism, etc.), many people may view transaction exposure as the more important exposure to manage rather than translation exposure. Transaction exposure will always come with the territory of certain foreign exchange businesses. Translation exposure should be managed as a higher priority when there are more books in more domestic currencies (i.e. when there are international operations and/or subsidiaries of the same firm) for the sake of accounting…and perhaps to prevent arbitrage losses?
What are the advantages and disadvantages of the common methods for controlling translation exposure? Common methods for controlling translation exposure include but are not limited to: Hedging through futures or forward contracts, swaps, or purchasing currency futures. An advantage would be when hedging can be doubled (or “double hedging”) thereby increasing the odds of a position being the right position to take because the investor can take both the long and short positions at once. The disadvantages to these
combinations of hedging techniques are the costs of the contracts themselves.
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