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International Finance and Transactional Exposure

Can someone help me out with two questions that I am struggling with comprehending. Can you provide in layman's term:

1) How does hedging help in limiting a company's transactional exposure?

2) How does a currency swap help in limiting transactional exposure?

Solution Preview

Please see response attached (also presented below), as well as two other relevant articles that you may find helpful. Good luck with your studies and take care.

RESPONSE:

1. How does hedging help in limiting a company's transactional exposure?

Transactional Exposure is the risk of loss from adverse foreign exchange movements that affect sterling values of Balance Sheet items held overseas and past transactions in foreign currency. Hedging can limit or manage a company's transactional exposure. It is the use of investments to manage commercial risk (i.e., transactional exposure, etc.), or to minimize a potential loss to an existing position or known commitment.

How? By using two counterbalancing investment strategies, any losses caused by price fluctuations are thus minimized. For example, a trader in commodities buys an amount of one particular item. At the same time he also makes a contract to sell an amount of a similar item at a later date. Thus if the price of the item he has bought falls, he can still recover money by selling the similar item at the earlier, higher price. (http://www.lse.co.uk/financeglossary.asp?searchTerm=&iArticleID=1795&definition=transactional_exposure).

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Solution Summary

This solution explains how hedging and currency swap help in limiting a company's transactional exposure. It is also supplemented with two highly informative articles.

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