Article Preview
Top1. Introduction
With globalization and liberalization being adopted by almost all countries, scope as well as sphere of international business has become much larger. There has been vast expansion of business beyond national boundaries all over the world. All of the business firms make efforts to acquire the required inputs from the cheapest source in the world and sell their output in the markets where they can get maximum return. Cross border trade transactions and financial flows involve exchange of one currency into other currency at some future date. But the continuous fluctuations in exchange rate results in risk in these activities. This risk is known as transaction exposure. Transaction exposure is a measure of adverse effect of movements of the exchange rate from the time foreign currency denominated transactions are initiated till the time of their final settlement. In other words, it measures the sensitivity of “realized” domestic currency values at the time of settling of outstanding, fixed priced contracted transactions resulting in future cash inflows and outflows denominated in foreign currencies to unexpected exchange rate changes. A real devaluation or revaluation of a particular currency can strongly affect the competitive position of local firms and their foreign competitors. Longer the time lag between entering into a sales/ purchase contract, shipment of goods and final payment higher is the risk of adverse movements in exchange rates which can convert a profitable deal into a loss. No doubt, it is not possible for any company to say that it has measured and covered all its transaction exposure. That is why efficient management of transaction exposure has become an alarming need. Usually it is stated that success of any MNC largely depends on how effectively it manages its transaction exposure.
Source of currency risk from transaction exposure for multinational companies could be either export/import activities, or borrowing/lending activities - anytime when future cash flows (to be paid or received) are fixed in a foreign currency. As a result of change in exchange rate, importers may require to pay extra for their imports, exporters may get lesser value for their exports, borrowers may required to pay extra and lenders may recover lesser amount. The resource-based companies face the uncertainty associated with the fact that while the commodities markets of the world are denominated in US Dollars or pounds sterling, their costs are denominated in local currencies. Exchange rate volatility is compounded by the fact that all factors that influence a currency's value have to be evaluated relative to every other currency – or at least every other major currency that is actively traded. While the commodity price cycle tends to be highly correlated with the world economic cycle – which stands to reason given that demand for commodities is based on demand for global production – there is no corresponding currency cycle, which makes it that much more difficult to anticipate what will be the value of any particular currency after one month, six months or twelve months.
In India, the major sources of transaction exposure are imports and exports. But an Indian importer sourcing products from abroad typically pays for them in the currency of the supplier, and then sells them in Indian Rupee at home. If the local currency appreciates relative to the Rupee, the importer must either raise prices at home to maintain margins, or contend with a reduction in profit. If the product faces competition in India from other importers or domestic producers, raising prices is not always an option. Similarly, if selling prices are contracted in advance, there is no opportunity to recover the foreign exchange loss that would result from an appreciation of the local currency. The Indian exporters face the same risk. A depreciating Indian Rupee is beneficial for them when they receive their funds in foreign currency. But any depreciation in foreign currency will erode their margins at the time of conversion of their foreign currency revenues into Rupee. The risk extends beyond the volatility of revenues and gross margins.