Assignment: What Factors Affect A Firm’s Degree Of Transacti ✓ Solved

Assignment: What factors affect a firm’s degree of transaction exposure

What factors affect a firm's degree of transaction exposure in a particular currency? For each factor, explain the desirable characteristics that would reduce transaction exposure. Explain how a U.S. corporation could hedge net receivables in Malaysian ringgit with a forward contract.

In this paper, we explore the critical factors influencing a company's transaction exposure to foreign currencies, with a focus on understanding how these factors can either mitigate or amplify financial risk. We also analyze practical hedging strategies, specifically how a U.S. corporation might use forward contracts to hedge net receivables denominated in Malaysian ringgit (MYR). The discussion is grounded in multinational finance principles, with insights drawn from relevant academic sources including Eiteman, Stonehill, & Moffett (2016).

Factors Affecting a Firm’s Degree of Transaction Exposure

1. The Nature and Timing of Foreign Transactions

Transaction exposure arises from the time gap between the initiation of a transaction and settlement. The timing of receivables and payables in foreign currency significantly influences exposure levels. For example, firms that operate with short-term transactions tend to have higher transaction exposure because currency fluctuations within the transaction period can substantially impact cash flows. Conversely, companies engaged in long-term contracts may experience reduced exposure if they can negotiate fixed exchange rates or incorporate currency adjustment clauses.

Desirable characteristics include the ability to lock in exchange rates or negotiate contracts with specific settlement dates that coincide with favorable currency movements, thus reducing exposure risk (Eiteman et al., 2016).

2. Currency Volatility and Market Liquidity

High volatility in a particular currency increases transaction exposure because unpredictability in exchange rate movements makes future cash flows more uncertain. Additionally, market liquidity influences the ease with which a firm can hedge its currency risks. Currencies with high liquidity—like the U.S. dollar or euro—allow for more efficient and cost-effective hedging, thereby reducing transaction exposure.

Low volatility and high liquidity are desirable features that contribute to minimized transaction risk. Firms operating in such environments can more accurately predict exposure and implement effective hedging strategies (Madura, 2020).

3. Contractual and Payment Terms

The specific terms and conditions negotiated in international contracts can significantly influence exposure. For instance, contracts that specify prices in the home currency transfer exchange risk to the buyer, thereby reducing the seller’s transaction exposure. Conversely, if prices are denominated in the foreign currency, the seller bears more risk unless hedged.

Firms should aim for contractual clauses that allow price adjustments or specify currency denominations aligned with their risk management strategies to minimize exposure.

4. Degree of Currency Hedging and Internal Measures

Proactive hedging policies, such as forward contracts, options, or swaps, can effectively reduce transaction exposure. Additionally, internal measures like diversification of markets and currency exposure, or matching foreign currency receivables and payables, can lessen risk. The firm's ability to implement these strategies depends on internal financial strength and market access.

Characteristics such as flexibility, availability of hedging instruments, and proactive risk management policies contribute to reduced overall transaction exposure (Hill, 2019).

Hedging Net Receivables in Malaysian Ringgit with a Forward Contract

A U.S. corporation expecting to receive payment in Malaysian ringgit (MYR) can hedge this net receivable through a forward contract. Such a contract establishes a fixed exchange rate for converting MYR to USD at a future date, thus locking in the currency value regardless of subsequent fluctuations.

Step-by-Step Process

1. Assessment of Exposure: Determine the amount of MYR receivables and the expected settlement date.
2. Entering a Forward Contract: The U.S. firm contacts a financial institution or foreign exchange broker to agree on a forward contract that matches the amount and timing of the receivable.
3. Hedging Management: Once the forward contract is secured, the firm is obligated to sell the specified MYR amount at the predetermined rate on the agreed date.
4. Settlement and Conversion: On the settlement date, the firm executes the contract, thereby converting MYR into USD at the fixed rate, eliminating exchange rate risk.

This hedging ensures predictable cash flows and shields the firm from adverse currency movements. Forward contracts are popular because they are straightforward, customizable, and cost-effective for hedging specific transaction exposures.

Conclusion

The degree of a firm's transaction exposure substantially depends on factors such as transaction timing, currency volatility and liquidity, contractual terms, and internal risk management strategies. Effective hedging methods, like forward contracts, serve as crucial tools in mitigating this risk, especially for companies involved in international trade, such as a U.S. firm with receivables in MYR. By understanding these factors and employing appropriate hedging strategies, firms can protect their financial health against unpredictable currency fluctuations, thereby ensuring stability and predictability in international operations.

References

• Eiteman, D., Stonehill, A., & Moffett, M. (2016). Multinational Business Finance (14th ed.). Pearson Learning Solutions.
• Madura, J. (2020). International Financial Management (13th ed.). Cengage Learning.
• Hill, C. W. (2019). International Business: Competing in the Global Marketplace (12th ed.). McGraw-Hill.
• Shapiro, A. C. (2017). Multinational Financial Management (10th ed.). Wiley.
• Levich, R. M. (2001). International Financial Markets. Irwin/McGraw-Hill.
• Shapiro, A. C. (2019). Multinational Financial Management (11th ed.). Wiley.
• Guseh, J. S., & McNatt, C. C. (2021). Efficient Foreign Exchange Markets: Theory and Empirical Evidence. Financial Management, 40(1), 23-53.
• Meyer, K. E. (2014). International Business. World Scientific Publishing.
• Dong, G., & Zhang, J. (2020). Exchange Rate Risk Management for Multinational Corporations. Journal of International Business Studies, 51(5), 769-785.
• Bartram, S. M., et al. (2022). An International Perspective on Hedging and Risk Management. Journal of Financial Economics, 145(2), 607-624.