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Let’s have an illustration to demonstrate how we can manage a transaction exposure risk:
Say if your company has just bought some chemical products from a Japanese supplier. This deal is denominated in Japanese Yen. You have 90 days to make payment and payment could be made by cheque or telegraphic transfer or by a letter of credit or documentary collection.
If you need to pay today, that’s no issue but since payment is in the future, the problem is that we do not know what the rates will be like in the future.

How would you then handle this transaction exposure risk?

You have four choices:

1. Do nothing.
   

If you firmly believe that the Yen will weaken against your currency then go right ahead and do nothing about hedging the exposure.
Your risk is the potential loss if your judgement is wrong.

2. Find a natural offset
   

What it’s mean is that you can find another receivable of the same amount due at about the same time. You can then use this receivable to pay off the obligation. This is a natural hedge or you call as matching. This is workable as long as you have a consistent flow of receivables and payables in Yen. Most bank would allow you keep a current account in a foreign currency account (FCA) denominated into your required foreign currency. From a practical standpoint, you can never expect amounts to match or tenors to match. Hence, it’s important not to let these receivables money idling. Thus if the receivable is due in 30 days time and the payable is due in 90 days time, you could place out the Yen funds for 60 days in order to match the cash-flow. Besides “doing this natural hedging”, you also is saving the transaction costs in terms of cutting down the number of FX transactions.

3. Book a forward contract
   

In my previous article, you know that a forward contract is a commitment between yourself and the bank to buy or sell a specific amount of a foreign currency on an agreed date in the future or within an agreed period in the future at the rate agreed upon in the present.
Amongst fellow finance executive, booking a forward contract is very common method use. Unfortunately, most of these booking are for supplier bills received.
Most financial executive does not know that this is not really a “true” hedging.  Strictly, to a be a real hedging, it should start from the ordering of goods or raw material process . The planning in the ordering of goods should be efficient so you can go to your bank to book or hedge your required currency.

4. Buy the Yen value spot and place it out as a deposit for 90 days till the day you have to remit the payment to the Japanese supplier.

This approach can be more costly than the forward contract as:

4.  
   • You need to sell your currency for yen which your bank will earn on the exchange spread,
   • If you are borrowing money for this period, this could be more expensive than the interbank rate,
   • There is also a likelihood that when you deposit the Yen for 90 days, the chance is you might be deposit at a rate below interbank.

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