year period.

The firm will pay a predetermined amount in INR each year, regardless of
future spot rates. In other words, the Indian firm has locked in the amount of INR the
GBP payments will convert to in ten years.

OPERATIONAL TECHNIQUES

Netting and offsetting

● A firm may have a transaction exposure portfolio with exposures in different currencies.
When exchange rates change, there may be gains on some currencies and losses on
others.
● Exposure netting is a portfolio approach to hedging, according to which a firm may
manage its trade transactions in such a way that exposures in one currency will be offset
by exposures in the same or other currencies.
● For example, suppose that a firm has receivables of USD 1 million and at the same time
payables of USD 1 million. So the USD receivables cancel out the USD payables, leaving
no net exposure.
● In case both the amounts are different, the firm can use the receivables to settle the
payables and hedge the residual or net amount of receivables or payables. A firm can
hedge the residual exposure (exposure remaining after netting) rather than hedging each
currency exposure separately when it has a portfolio of currency exposures.
● If two currencies are positively correlated, a firm can offset a long position in one
currency with a short position in the other currency. This provides a natural hedge.
● However, if two currencies are negatively correlated, then a long position in one currency
can be offset by a long position in the other currency and vice versa.

Currency of invoicing

● Importers and exporters can also shift foreign exchange exposure by getting their exports
or imports invoiced in their own currency.
● This method of hedging does not eliminate foreign exchange exposure but shifts it from
one party to another.
● For example, if a firm invoices its imports in its domestic currency, it need not face
foreign exchange exposure on its payables. But the counter-party (i.e., the exporter) will
face the foreign exchange exposure.
 ● It is also a common practice for both parties—the exporter and the importer—to agree to
use a currency other than their respective currencies to invoice their transactions. For
example, an Indian exporter and a Japanese importer may agree to use the U.S. dollar as
the invoice currency.
● Further, in the case of some currencies, there may not be a regular market for currency
derivatives like options and futures. Therefore, traders may use a third currency, which is
less volatile in value or whose country of origin has a developed currency derivative
market.
● Sometimes, exporters and importers agree to share the foreign exchange exposure by
getting a part of the trade invoiced in, say, the importer's home currency, and the rest of
the trade invoiced in the exporter's home currency. Such invoicing is known as mixed
currency invoicing.
● Trade transactions may also be invoiced in one of the standard currency baskets such as
euro or SDR, and thereby the foreign exchange exposure is reduced. Trade transactions
may also be expressed in terms of composite currency unit made of different currencies.
Such private currency baskets, also known as cocktails, are designed to avoid violent
fluctuations in individual exchange rates.
● Sometimes, however, neither of the parties involved may have any choice, as in the case
of crude oil exports, which are conventionally invoiced in the U.S. dollar.

Leading/lagging strategy

● Transaction exposure can also be managed by shifting the timing of receipt or payment of
foreign currency in accordance with expectations of future exchange rate movements.
● A firm may lag the receivables and lead the payables in hard currencies.
● It may also lead the receivables and lag the payables denominated in weak currencies.
● By doing so, it can avoid the loss from the depreciation of the soft currency and benefit
from the appreciation of the hard currency.
● For example, suppose that an Indian firm has three-month payables denominated in U.S.
dollars. As the U.S. dollar is a strong currency and is expected to appreciate against the
Indian rupee, any delay in the settlement of the U.S. dollar payables will put additional
burden on the Indian firm. Therefore, the firm may settle the payment immediately and
avail the cash discount, if any.
● Conversely, if the firm has receivables in a weak currency (e.g., Hungary's currency, the
forint), it may lead the receivables. As weak currencies are expected to depreciate, any
delay in the settlement of receivables will reduce the amount of receivables in terms of
home currency.