Looking for the answer to the question below related to Financial Management ?
All are methods of Internally managing foreign exchange risk except .
|A. exposure netting
B. leading & lagging
C. denomination in local currency
D. forward contract
The Correct Answer Is:
- D. forward contract
The correct answer is D. forward contract. A forward contract is a method of externally managing foreign exchange risk, not internally. To understand why this answer is correct and why the other options (A, B, and C) are methods of internally managing foreign exchange risk, let’s delve into each of them:
D. Forward Contract –
This option is correct. A forward contract is a financial derivative that allows two parties to agree to exchange a specific amount of one currency for another currency at a future date, at an agreed-upon exchange rate.
It is an external risk management method because it involves entering into a contract with a third party (usually a financial institution) to hedge against potential foreign exchange risk. The purpose of a forward contract is to lock in an exchange rate in advance to mitigate the impact of unfavorable exchange rate movements.
Now, let’s discuss why the other options are methods of internally managing foreign exchange risk:
A. Exposure Netting –
Exposure netting, also known as exposure matching, is an internal risk management technique. It involves aligning a company’s foreign currency inflows (receipts) and outflows (payments) in such a way that they naturally offset each other. By doing this, the company reduces the need for external transactions and foreign exchange risk.
B. Leading & Lagging –
Leading and lagging are internal techniques used by companies to manage their foreign exchange risk by adjusting the timing of their foreign currency payments and receipts. Leading involves making foreign currency payments earlier than required, while lagging involves delaying foreign currency payments. These strategies help to take advantage of favorable exchange rate movements or avoid unfavorable ones.
C. Denomination in Local Currency –
Denominating transactions in the local currency of the foreign entity is another internal method of managing foreign exchange risk. This approach reduces the exposure to fluctuations in exchange rates by conducting transactions in the local currency, eliminating the need to convert to the company’s home currency.
To further understand the differences between internal and external methods of managing foreign exchange risk:
- Internal methods, like exposure netting, leading and lagging, and denomination in local currency, focus on how a company conducts its operations and transactions to minimize exposure to foreign exchange risk. These methods are entirely under the control of the company and do not involve external parties.
- External methods, such as forward contracts, options contracts, and currency swaps, involve financial instruments and agreements with third parties, such as banks or financial institutions. These methods provide a means of mitigating foreign exchange risk through contracts and derivatives.
Companies often use a combination of internal and external methods to effectively manage foreign exchange risk, depending on their specific circumstances and the nature of their international operations. The choice of method depends on factors such as the company’s risk tolerance, exposure to foreign exchange fluctuations, and market conditions.
In summary, the correct answer is D. forward contract because it is an external method of managing foreign exchange risk. Exposure netting, leading and lagging, and denomination in local currency are all internal methods that involve adjusting internal business practices to minimize exposure to foreign exchange risk.
Companies use these methods in conjunction with external methods like forward contracts to create a comprehensive foreign exchange risk management strategy.