DEFINITION of 'Exposure Netting '
A method of hedging currency risk by offsetting exposure in one currency with exposure in the same or another currency. Exposure netting has the objective of reducing a company’s vulnerability to exchange rate risk. It is especially applicable in the case of a large company, whose various currency exposures would be managed as a single portfolio, since it would be infeasible and impractical to hedge each and every currency exposure individually. A firm’s exposure netting strategy depends on a number of factors, including the currencies and amounts involved in its payments and receipts, the corporate policy with regard to hedging currency risk, the correlations between the different currencies to which it has exposure, etc.
BREAKING DOWN 'Exposure Netting '
If the correlation between exposure currencies is positive, a company would adopt a long-short strategy for exposure netting. This is because, with a positive correlation between two currencies, a long-short approach would result in gains from one currency position offsetting losses from the other. Conversely, if the correlation is negative, a long-long strategy would result in an effective hedge in the event of currency movement.
Assume Widget Co, located in Canada, has imported machinery from the United States and regularly exports to Europe. The company has to pay $10 million to its U.S. machinery supplier in three months, at which time it is also expecting a receipt of EUR 5 million and CHF 1 million for its exports. The spot rate is EUR 1 = USD 1.35 and USD 1 = CHF 1.10. How can Widget Co. use exposure netting to hedge itself?
The company’s net currency exposure is USD 2.15 million (i.e. 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, since a stronger Canadian dollar would result in U.S. dollars becoming cheaper in three months. On the other hand, if the company is concerned the Canadian dollar may depreciate against the U.S. dollar, it may elect to lock in its exchange rate in three months through a forward contract or a currency option. Exposure netting is thus a more efficient way of managing currency exposure by viewing it as a portfolio, rather than hedging each currency exposure separately.