It is, usually, not possible to totally eliminate both translation exposure and transaction exposure. In few cases, the elimination of one exposure will as well eliminate the other. But in another cases, the elimination of one exposure in fact makes the other. Discuss which exposure might be viewed like the most significant to effectively manage, if a conflict between controlling both takes place. As well, discuss and critique the common techniques for controlling translation exposure.
Answer: As it is, usually, not possible to completely eliminate both transaction and translation exposure, we suggest that transaction exposure be given first priority as it includes real cash flows. The translation procedure, on-the-other hand, has no direct influence on reporting currency cash flows, and will just have a realizable effect on net investment upon the sale or liquidation of the assets.
There are two general methods for controlling translation exposure: a balance sheet hedge and a derivatives hedge. The balance sheet hedge includes equating the amount of exposed assets in an exposure currency along with the exposed liabilities in that currency, thus the net exposure is zero. So when an exposure currency exchange rate changes versus the reporting currency, the change in assets will offset the change in liabilities. To form a balance sheet hedge, one time transaction exposure has been controlled, frequently means creating new transaction exposure. This is not wise as real cash flow losses can result. A derivatives hedge is not actually a hedge, but rather a speculative position, as the size of the “hedge” is based upon the future expected spot rate of exchange for the exposure currency with the reporting currency. If the actual spot rate that is different from the expected rate, the “hedge” may result in the loss of real cash flows.