What is exposure compensation?
Exposure compensation is a method of hedging currency risk by offsetting exposure in one currency with exposure in the same or a similar currency.
- The offset offsets the value of multiple positions or payments that must be exchanged between two or more parties.
- Exposure compensation is achieved within a company where you can find an offsetting position in two or more currencies or other risk factors within various segments of the company.
- Offset reduces the cost of a company and makes it easier to manage risk, as offset positions do not need to be hedged individually for risk exposures.
Understanding Exposure Compensation
Exposure compensation aims to reduce a company’s exposure to exchange rate (currency) risk. It is especially applicable in the case of a large multinational company, whose various currency exposures can be managed as a single portfolio; It is often difficult and expensive to hedge each and every currency risk for an individual client when dealing with many international clients.
A company’s exposure compensation strategy depends on a number of factors, including the currencies and amounts involved in its payments and collections, corporate policy regarding currency risk hedging, and potential correlations between the different currencies to which it is subject. the ones that are exposed.
Exposure compensation allows companies to manage their currency risk more comprehensively. If a company finds the correlation between the exposure currencies to be positive, the company will adopt a long-short strategy to offset the exposure. The reason for doing so is that with a positive correlation between two currencies, a long-short approach would result in gains from one currency position that would offset losses from the other. On the contrary, if the correlation is negative, a long-term strategy would lead to effective hedging in case of currency movements.
Exposure compensation can also be done to offset the risks of a large portfolio or finance company among their portfolios. As an enterprise risk management (ERM) strategy, if a bank’s A portfolio is 1,000 Apple shares long (AAPL) and another B portfolio is short 1,000 Apple shares, Apple’s positions and price exposure will be they can compensate at the administrative level.
Exposure compensation generally refers to the compensation that occurs within an organization between its various units, projects, or portfolios, making it a one-sided compensation.
Exposure compensation example
Suppose the Widget Co., located in Canada, has imported machinery from the United States and regularly exports to Europe. The company must pay 10 million dollars to its US machinery supplier in three months, at which point it also expects to receive 5 million euros and 1 million Swiss francs for its exports. The spot exchange rate is 1 EUR = 1.35 USD and 1 CHF = 1.10 USD. How can Widget Co. use exposure compensation to protect itself?
The company’s net foreign exchange exposure is USD $ 2.15 million (that is, USD $ 10 million – [(5 x 1.35) + (1 x 1.10)]). If Widget Co. is confident that the Canadian dollar will appreciate over the next three months, it would do nothing, as a stronger Canadian dollar would make US dollars cheaper in three months. On the other hand, if the company is concerned that the Canadian dollar may depreciate against the US dollar, it can choose to fix its exchange rate in three months through a forward contract or an exchange option. Exposure compensation is therefore a more efficient way of managing currency exposure as a portfolio, rather than hedging each currency exposure separately.