Different companies take different approaches to attempt to limit the impact of the currency volatility that exists when committing to a foreign currency denominated transaction. Sometimes US companies use certain protective measures like invoicing all transactions in dollars to avoid dealing with looses incurred by exchange rate changes. There are seven methods of hedging used to manage transaction exposure and they include forward market share, risk shifting, exposure netting, currency risk sharing, cross hedging, and foreign currency options. When a company uses a forward market hedge it sells its foreign currency forward if it is long a foreign currency company. However that company would buy the foreign currency forward if it was a short foreign currency company. This hedging technique ultimately results offsetting a gain or a loss on a forward contract with a gain or loss on the receivable. A very common type of hedging strategy used in international business is risk shifting. This method allows a company to invoice exports in strong currencies for example in dollars. Rather than eliminate the risk overall this method shifts the risk from one currency to the other for example from euro exposure to dollar exposure. Exposure netting allows multinational corporations to offset exposure in one currency with exposure in another currency. A company can also offset a long position with a short position in another currency if the two currencies are positively correlated, however if they are negatively correlated the company would then do the opposite and use short positions to offset the other. When using the currency risk sharing method both companies compromise by sharing the risk of changes in the exchange rate. This is done by creating a customized hedge contract where both companies agree to have a price adjustment clause where the base price will be adjusted in the event that exchange rates change. The currency collar method allows a company to purchase a contract which protects them from losses if the currency moves outside a given range. The cross hedge method is typically used when forward contracts are not available for a certain currency; this method allows a company to hedge for transaction exposure using a futures contract on a different currency that is related to the currency wanting to be hedged for. When using the foreign currency options method a company agrees to purchase an option to sell a specific amount to another party such as bank for a specific price such as the current exchange rate. In the event that the exchange rate negatively impacts the company’s revenue the company would only incur the loss of paying out for the currency option but would ultimately get projected revenue. However it is very important to understand that hedging to eliminate transaction risk places multinational corporations in a good position but will not eliminate foreign exchange risk, these methods only limit the risk that companies are exposed to.

Sources:

http://www.allbusiness.com/finance/630482-1.html, accessed October 31, 2009.