The basic hedge strategy for reducing the translation exposure is to increase hard-currency (likely to appreciate) assets and decrease liabilities. By the same token, soft currency (likely to depreciate) assets need to be decreased and liabilities need to be increased. With this concept of basic strategy, there are three ways to manage translation exposure that arises when local currency is converted to the home currency for reporting and consolidating financial statements. They are adjusting fund flows, entering into forward contracts, and exposure netting.

The first method is adjusting fund flows which is done by altering either the amounts or the currencies (or both) of the planned cash flows of the parent or its subsidiaries to reduce the firm’s local currency accounting exposure. When the local currency is expected to depreciate, examples of direct funds-adjustment method are pricing exports in the home currency (hard-currency) and imports in the local currency (soft currency), and replacing hard currency loan with soft currency loan. Indirect methods are to adjust transfer prices of the sales of goods, speeding up the payment of dividends, fees, and royalties, and adjusting the leads and lags of intersubsidiary accounts. Some techniques, such as adjusting the speed of payment of dividends and fees and royalties, however, are not usually under the treasurer’s control, and may take considerable lead time.

The second method is to entering into forward contract. This is the most popular coverage technique which reduces translation exposure by creating an offsetting currency position such that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. For example, a U.S. company which has a branch in UK has £40 million translation exposure, which means sterling assets exceed sterling liabilities by that amount. The company can eliminate the exposure by selling £40 million forward to buy U.S. dollars. Any loss (gain) on its translation exposure will then be offset by a corresponding gain (loss) on its forward contract.

Finally, the third method is exposure netting, also called balance-sheet hedge, which is an additional exchange-management technique available to multinational firms with positions in more than one foreign currency. This method equates the amount of exposed assets in an exposure currency with the exposed liability in that currency; therefore, gains and losses on the currency positions will offset each other.

Sources:

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