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When a company has receipts & payments in the same foreign currency due at the same time, it can use technique of managing foreign exchange risk.

When a company has receipts & payments in the same foreign currency due at the same time, it can use technique of managing foreign exchange risk.

Looking for the answer to the question below related to Financial Management ?

When a company has receipts & payments in the same foreign currency due at the same time, it can use technique of managing foreign exchange risk.

 Options:

A. risk sharing agreement
B. leading
C. lagging
D. exposure netting (matching)

The Correct Answer Is:

  • D. exposure netting (matching)

The correct answer is D. exposure netting (matching). When a company has receipts and payments in the same foreign currency due at the same time, exposure netting (matching) is a risk management technique that can be employed to minimize foreign exchange risk. Let’s delve into why this answer is correct and why the other options (A, B, and C) are not typically used in this specific scenario:

D. Exposure Netting (Matching) –

This option is correct. Exposure netting, also known as exposure matching, is a risk management strategy where a company offsets its foreign exchange exposure by matching receipts and payments in the same currency and at the same time. By doing so, the company reduces the need to engage in foreign exchange transactions, thus minimizing foreign exchange risk.

Exposure netting works effectively when a company has both foreign currency inflows (receipts) and outflows (payments) that align in terms of currency and timing. For example, if a multinational company has export revenues in euros and import expenses in euros, and these transactions coincide in time, they can naturally offset each other without the need for currency conversion.

Now, let’s discuss why the other options are not suitable for managing foreign exchange risk in this specific scenario:

A. Risk Sharing Agreement –

A risk-sharing agreement involves a contractual arrangement where two parties agree to share the foreign exchange risk associated with a transaction. It does not directly address the scenario of having receipts and payments in the same foreign currency due at the same time. Instead, it focuses on risk allocation between parties in a business transaction.

B. Leading –

Leading refers to the practice of settling a foreign exchange obligation before it is due. Leading is typically used to accelerate the receipt of foreign currency or to prepay foreign currency obligations. It is not specifically related to matching receipts and payments in the same currency and at the same time.

C. Lagging –

Lagging, on the other hand, is the opposite of leading. It involves delaying the settlement of a foreign exchange obligation. Lagging is used to postpone the payment of foreign currency obligations or to delay the conversion of foreign currency receipts into the domestic currency. Like leading, it is not directly related to matching foreign currency receipts and payments.

Exposure netting, also known as natural hedging, is an efficient way to reduce foreign exchange risk, as it leverages the inherent balance in cash flows denominated in the same foreign currency. This approach simplifies financial operations and reduces transaction costs and exposure to exchange rate fluctuations.

In addition to exposure netting, companies may also use other risk management techniques to address foreign exchange risk, depending on their specific circumstances:

1. Forward Contracts:

If exposure netting is not feasible due to timing mismatches or different currencies, a company may use forward contracts to lock in exchange rates for future transactions.

2. Options Contracts:

Options give companies the right, but not the obligation, to exchange currencies at a predetermined rate. This can be used for added flexibility in managing foreign exchange risk.

3. Hedging Policies:

Companies may implement formal hedging policies to outline their approach to managing foreign exchange risk. These policies may involve a combination of strategies, including exposure netting and financial derivatives.

4. Cash Flow Forecasting:

Accurate cash flow forecasting helps companies identify foreign exchange exposure early, allowing them to implement the most appropriate risk management strategies.

In conclusion, the correct answer is D. exposure netting (matching) because it is a suitable technique when a company has receipts and payments in the same foreign currency due at the same time.

By aligning these cash flows, companies can naturally offset their foreign exchange exposure and reduce the need for foreign exchange transactions, minimizing risk associated with exchange rate fluctuations. Other options, such as risk-sharing agreements, leading, and lagging, are not typically used in this specific scenario of matching foreign currency cash flows.

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