Question

(1)(a)What is exchange rate risk? Distinguish between Transaction Exposure and Economic exposure to exchange rate movements. (b)Consider the following information: 90-day U.S interest rate..... ..4% 90-day Malaysian interest rate.. .3% 90-day forward rate for the Malaysian Ringgit $0.400 Spot Rate of Malaysian Ringgit ..$0.404 Assume a U.S based MNC will need 300,000 Ringgit in 90 days and wishes to hedge this payable position. Would it be better off using a FORWARD hedge or MONEY MARKET hedge?

Answer 1

Per Chegg's guidelines, answered first question only. If you need answers to other questions, pls post them separately, sorry

Exchange-rate risk, also called currency risk, is the risk that changes in the relative value of certain currencies will reduce the value of investments denominated in a foreign currency. This risk refers to the losses that an international financial transaction may incur due to currency fluctuations.

Transaction exposure arises from the effect that exchange rate fluctuations have on a company’s obligations to make or receive payments denominated in foreign currency. This type of exposure is short-term to medium-term in nature.

Economic exposure is is caused by the effect of unexpected currency fluctuations on a company’s future cash flows and market value and is long-term in nature. The impact can be substantial, as unanticipated exchange rate changes can greatly affect a company’s competitive position, even if it does not operate or sell overseas. For example, a U.S. furniture manufacturer who only sells locally still has to contend with imports from Asia and Europe, which may get cheaper and thus more competitive if the dollar strengthens markedly.

Unlike transaction exposure, economic exposure is difficult to measure precisely and hence challenging to hedge. Economic exposure is also relatively difficult to hedge because it deals with unexpected changes in foreign exchange rates, unlike expected changes in currency rates, which form the basis for corporate budgetary forecasts.