Controlling the translation exposure

Question

It is, normally, not possible to fully remove both the translation exposure and transaction exposure.  In some cases, eradication of one exposure will also eliminate the other.  However in other cases, removal of one exposure really creates the other.  Illustrate which exposure might be viewed as the most significant to efficiently manage, in case conflict between controlling both arises.  Also, critique and discuss the common methods in order to control the translation exposure.

Answer 1

As it is, normally, not possible to entirely remove both translation and transaction exposure, we suggest that transaction exposure should be given the first priority as it includes real cash flows. Translation process, otherwise, has no direct effect on reporting currency cash flows, and will have a realizable effect on the net investment on the sale or liquidation of assets.

There exist two methods in order to control the translation exposure:  balance sheet and derivatives hedge.  Balance sheet hedge includes equating the amount of exposed assets in an exposure currency along with exposed liabilities in that currency, so net exposure is zero.  Therefore, when an exposure currency exchange rate changes versus reporting currency, change in assets will offset change in the liabilities. For creating the balance sheet hedge, as the transaction exposure has been controlled, generally means creation of new transaction exposure.  It is not wise as real cash flow losses can result. Derivatives hedge is not really a hedge, instead a speculative position, as size of ‘hedge’ is based on future expected spot rate of exchange for the exposure currency with the reporting currency.  In case actual spot rate differs from the expected rate, ‘hedge’ may result in loss of real cash flows.