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Unit 3 of 4 · M.Com Sem 3

Unit 3: Exposure and risk management

International Financial Management notes · PTU syllabus (MCOPAF312-18)

3 min read4 topics10 exam questions
On this page
  1. Unit summary
  2. Foreign exchange exposure: concept and relevance
  3. Managing transaction exposure
  4. Translation and economic exposure
  5. Interest rate and equity exposure
  6. Key terms
  7. Quick revision
  8. Important questions

Unit summary

Exchange rate changes affect a firm's transactions, accounts and competitiveness. This unit covers the concept and relevance of foreign exchange exposure, management of transaction, translation, economic and interest rate exposure, and hedging equity, currency and interest rate exposures using derivatives.

After this unit you can

  • Explain the types of foreign exchange exposure and their relevance
  • Manage transaction exposure using forwards, money market hedges, options and internal techniques
  • Explain translation and economic exposure management
  • Hedge interest rate and equity exposure using derivatives

PTU syllabus topics

  • Foreign exchange exposure concept and relevance
  • management of economic/transaction/translation/interest rate exposure
  • hedging against equity
  • currency and interest rate exposure using derivatives
ComparisonTypes of foreign exchange exposure
What is at risk
Managed by

Transaction exposure

Cash flows of contracts already made

Forwards, futures, options, netting

Translation exposure

Reported values in consolidated accounts

Balance sheet hedging

Economic exposure

Future cash flows and firm value

Diversified sourcing and markets

1

Topic 1

Foreign exchange exposure: concept and relevance

Exposure is the sensitivity of a firm's cash flows, earnings or value to unexpected changes in exchange rates.

ClassificationTypes of exposure
Exposure

  • Transaction exposure

    Effect on contracted foreign currency receivables and payables

  • Translation (accounting) exposure

    Effect on consolidated financial statements of foreign subsidiaries

  • Economic (operating) exposure

    Effect on future cash flows and competitive position

  • Relevance: reduces volatility of cash flows, avoids distress costs, improves planning; critics argue shareholders can diversify — but market imperfections make hedging valuable.
2

Topic 2

Managing transaction exposure

ClassificationHedging techniques
Transaction exposure hedging

  • Forward contract

    Lock rate for future receipt/payment

  • Money market hedge

    Borrow/lend in currencies to create offsetting position

  • Futures

    Exchange-traded hedge

  • Options

    Protection with upside

  • Internal techniques

    Invoicing in home currency, leading and lagging, netting, matching, exposure netting

Example

Importer owes US$ 100,000 in 3 months. Spot ₹83, forward ₹83.60. Money market hedge: invest the PV of $100,000 at US rate (4% p.a. → 1% for 3 months) = $99,010; buy dollars now = ₹82,17,830; borrow this in India at 8% p.a. (2% for 3 months) → repay ₹83,82,187 — compare with forward cost ₹83,60,000 → forward is cheaper.

3

Topic 3

Translation and economic exposure

  • Translation exposure management: balance sheet hedge (match exposed assets and liabilities in the same currency), funds adjustment, derivatives; not a cash flow issue, but affects reported earnings and covenants.
  • Economic exposure management: diversify production and sourcing across countries, flexible pricing, product differentiation, financing in foreign currencies to match revenues, R&D for competitiveness.
4

Topic 4

Interest rate and equity exposure

  • Interest rate exposure: floating-rate borrowings and investments; managed with interest rate swaps, forward rate agreements (FRAs), interest rate futures, caps, floors and collars.
  • Equity exposure: hedged with index futures and options (e.g., Nifty futures to hedge a portfolio — hedge ratio = portfolio value × beta ÷ futures value).
Key formulasHedge ratios

  • Index futures hedge contracts

    (Portfolio value × β) ÷ (Futures price × Lot size)

  • Minimum variance hedge ratio

    h = ρ × σspot ÷ σfutures

Example

Portfolio ₹1 crore with β 1.2; Nifty futures at 24,000, lot 75 → contracts = 1,20,00,000 ÷ 18,00,000 ≈ 7 lots sold to hedge.

Key terms

Transaction exposure
Exchange rate risk on contracted cash flows
Translation exposure
Accounting exposure on consolidation
Economic exposure
Effect of exchange rates on future cash flows and value
Money market hedge
Hedging using borrowing and lending in two currencies
Leading and lagging
Changing timing of payments to manage exposure

Quick revision

  • Exposures: transaction, translation, economic.
  • Transaction hedges: forward, money market, futures, options, internal techniques.
  • Translation: balance sheet hedge; economic: operational strategies.
  • Interest rate hedges: swaps, FRAs, caps, floors, collars.
  • Equity hedges: index futures, beta-adjusted hedge ratio.

Important exam questions

Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).

Short-answer questions

  1. Q1.What is transaction exposure?
  2. Q2.Distinguish translation and economic exposure.
  3. Q3.What is a money market hedge?
  4. Q4.What is netting?
  5. Q5.What is a forward rate agreement?
  6. Q6.How is the number of index futures contracts for hedging computed?

Long-answer questions

  1. Q1.Explain the types of foreign exchange exposure and their relevance.
  2. Q2.Explain techniques of managing transaction exposure with an illustration.
  3. Q3.Explain the management of translation and economic exposure.
  4. Q4.Explain hedging of interest rate and equity exposure using derivatives.

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