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Hedging Continual Economic Exposure

Consider a real-world dilemma face by many firms that rely on exporting. Clark Financing, Inc. produces its products in its factory in Texas and exports most of the products to Mexico each month. The exports are denominated in pesos. Clark Financing Inc. recognizes that hedging on a monthly basis does not really protect against long-term movements in exchange rates. It is also recognizes that it could eliminate its transaction exposure by denominating the exports in pesos, but that it still would have economic exposure (because Mexican consumers would reduce demand if the peso weakened). Clark Financing does not know how many pesos it will receive in the future, so it would have difficulty even if a long-term hedging method was available.

How can Clark Financing realistically deal with this dilemma and reduce its exposure over the long-term? Keep in mind there is no perfect solutions.

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Multinational firms must constantly assess the business environments of the countries they are already operating in as well as the ones they are considering investing in. Here Clark has to consider the business environment of Mexico. They have to consider following type of exposures:

Types of exposure

Transaction exposure
It is the extent to which given exchanges rate change will change the value of foreign currency denominated transactions already entered into.
Measurement of Transaction Exposure

* Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely
o Purchasing or selling on credit goods or services when prices are stated in foreign currencies
o Borrowing or lending funds when repayment is to be made in a foreign currency
o Being a party to an unperformed forward contract and
o Otherwise acquiring assets or incurring liabilities denominated in foreign currencies
http://www.businessfaculty.utoledo.edu/pkozlowski/FINA3500/ch08.ppt.
Translation (Accounting) exposure
The change in the value of a firm's foreign currency denominated accounts due to a change in exchange rates.

Economic exposure
It measures how greatly a firm's present value of future cash flows is affected by unexpected exchange rate fluctuations.

Comparison

Transaction exposure arises whenever a company is committed to a foreign-currency-denominated transaction. Since the transaction will result in a future foreign currency cash inflow or outflow, any change in the exchange rate between the time the transaction is entered into and the time it is settled in cash will lead to a change in the dollar (Home Currency) amount of the cash inflow or outflow.

Transaction exposure is a subset of economic exposure. ...

Solution Summary

This solution considers a real-world dilemma faced by many firms who rely on exporting. The expert explains how Clark Financing can realistically deal with the dilemma and reduce its exposure over the long-term.

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