Hedging Translation & Operating Exposure – Strategies

Since these exposures (Translation & Operating) don't involve immediate cash outflows, using Forward Contracts is expensive and ineffective. We use structure, not instruments.

1. Hedging Translation Exposure

A "Paper Loss" needs a "Paper Hedge".

The Balance Sheet Hedge

• Concept: Match Foreign Currency Assets with Foreign Currency Liabilities.
• Logic:
  • If you have a Factory in UK worth £100M (Asset).
  • Take a Loan in UK worth £100M (Liability).
  • Result: If Pound falls, Asset value drops (Loss), but Liability value also drops (Gain). They cancel out. Net Exposure = 0.
• Pros: Zero cost (if interest rates are similar).
• Cons: Increases Debt-Equity ratio.

2. Hedging Operating Exposure

A "Strategic Risk" needs a "Strategic Hedge".

A. Diversification of Operations

• Don't build all factories in one country.
• Example: Toyota has plants in Japan, USA, and Europe. If Yen rises, US plant becomes more competitive.

B. Diversification of Financing

• Borrow in multiple currencies.
• Example: If you have sales in Euro, borrow in Euro. You can use the sales revenue to pay the loan interest directly (Natural Hedge).

C. R&D Investment

• Innovate so much that price doesn't matter. (e.g., Tesla, Apple).

3. Exam Notes: Writing the Answer

Question: "Explain Balance Sheet Hedge." (5 Marks)

Answering Strategy:

1. Goal: To neutralize Translation Exposure.
2. Method: Creating a Liability to match an Asset.
3. Effect: Exchange rate changes affect both sides equally, leaving Net Worth unchanged.

Summary

• Transaction Hedge: Uses Financial Markets (Forwards).
• Translation Hedge: Uses Accounting Structure (Matching Assets/Liabilities).
• Operating Hedge: Uses Business Strategy (Location/Product).

Quiz Time! 🎯

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