Glossary

Transaction exposure is the degree to which future FX-denominated cash flows from contractually binding transactions are affected by currency fluctuations. Transaction exposure exists whether or not the corresponding receivables/payables have been created. Some elements of transaction exposure are included in the firm’s accounting exposure This is the case of AR/AP receivables/payables) that have been created and appear on the balance sheet. Other elements of transaction exposure, such as contractually binding SO/PO (sales/purchase orders) not appearing on the balance sheet, are part of the firm’s operating exposure). Transaction exposure, because of its significance in terms of profit margins and cash flows, is the most widely hedged FX exposure.

Transaction exposure management is the hedging of future FX-denominated cash flows that result from contractually binding transactions, whether or not the corresponding receivables/payables have been created. In transaction exposure management, currency forwards are booked for SO/POs (sales orders/purchase orders) and/or AR/AP (accounts receivable/accounts payable). Transaction exposure management requires constant vigilance, as new orders keep on arriving. It is best implemented with Currency Management Automation solutions that allow firms to monitor and hedge their FX transaction exposure in any currency pair, whatever the number of transactions and their size.

Transaction risk is the possibility of incurring future gains or losses on foreign currency-denominated existing transactions, as FX rates fluctuate between the moment the transaction is agreed and the moment it is settled. Transaction risk is measured currency by currency. Transactions go through several phases: forecast, firm commitment (sales order/purchase order), balance sheet items (accounts receivable/payable), settlement. Because a firm commitment typically precedes the creation of the corresponding balance sheet item, transaction risk arises before accounting risk. Transaction risk can be hedged in any number of currency pairs and for any number of transactions, however small. This is accomplished with Currency Management Automation solutions in the three phases of the hedging process: pre-trade (exposure collection and monitoring), trade (forward transaction execution), and post-trade (reporting management).

Translation risk is the possibility that the translation into a company’s assets, liabilities, revenues, expenses, gains and losses that are denominated in foreign currencies will result in foreign exchange gains and losses. Translation risk is also known as accounting risk. Unlike transaction risk, translation risk reflects paper gains and losses determined by the accounting rules that prevail in each country. It is retrospective because it is based on activities that occurred in the past.

Translation account exposure management refers to the methods used when a firm restates, in the currency in which a company presents its financial statements, of all assets, liabilities, revenues, expenses, gains and losses that are denominated in foreign currencies. This process of foreign currency translation results in accounting FX gains and losses. There are three main translation account exposure management methods available. With the current/noncurrent method, all the foreign exchange denominated current assets and liabilities are translated at the current exchange rate, while non-current assets and liabilities are translated at the historical exchange rate. With the monetary/nonmonetary method, monetary items such as cash, accounts receivable and payable, are translated at the current exchange rate, while nonmonetary items (inventory, fixed assets) are translated at the historical exchange rate. Finally, with the current rate method, all balance sheet and income statement items are translated at the current exchange rate. No matter what translation account exposure management method is used, the resulting FX gains and losses are paper only, and rarely affect cash flows.

Under-hedging is to the application of a lower-than-optimal optimal hedge ratio to hedge a given FX exposure. Under-hedging is common when forward points are ‘against’ a company, for example when a European firm sells in Emerging Markets currencies that trade at a forward discount to EUR. Risk managers are naturally reluctant to sell these currencies in forward markets, given the high cost of carry. Under-hedging, in such a situation, can be counter-productive. This is because currencies with a high cost of carry tend to be highly volatile and can cause severe losses. The solution is to use Currency Management Automation solutions to calculate a weighted-average rate of all individual pieces of exposure and to build a ‘tolerance’ (in % terms) around that benchmark rate. Then, ‘take-profit’ and ‘stop-loss’ orders are automatically set, allowing the firm to effectively delay the execution of the trades, and thus to take shorter-maturity hedges that create savings on the carry.

Unrealised FX gains or losses reflect the change in the value of foreign currency denominated sales/purchase transactions that are recorded in financial statements prior to the settlement of the invoices. For example, a U.S.-based company sells EUR 100,000 worth of motor vehicle parts to a European distributor. When the invoice was recognised, the spot EUR-USD rate was 1.10. As financial statements are drawn, the transaction hasn’t been settled still, and the exchange rate has moved to 1.15. The corresponding unrealised FX gain of USD 5,000 is recorded on the balance sheet under the owner’s equity section.

In a currency transaction, the value date (VD) is the date at which the trade is settled and one currency is exchanged against another. In a spot market transaction the most common value date is two days after the transaction was agreed If the value date is more than 48 hours away from the day the transaction was agreed, it is called a forward market transaction. It can be weeks, months or, in cases involving very liquid currencies such as USD and EUR, even years after the contract has been signed. In forward markets, the value date is freely agreed between the buyer and the seller. This is not the case with futures markets transactions, where the VD is standardised by the futures exchange.

A vanilla currency option is a financial derivative instrument that gives the buyer the right —but not the obligation— to buy (in a ‘call’ option), or to sell (in a ‘put’ option) the contracted currency at a set price or exchange rate (known as the ‘strike price’), on a predetermined expiration date. The seller of the option must fulfill the contract if the buyer so desires. The term ‘vanilla’ or ‘plain vanilla’ is used to signify that the contract has no other special features that would turn it into an ‘exotic’ option. When hedging regular foreign currency inflows and outflows, forward contracts are more widely used than options. However, vanilla currency options can be an efficient tool when contingent business events are hedged.