What Is Exposure Netting?
Exposure netting is a method of hedging currency risk by offsetting exposure in one currency with exposure in the same or another similar currency.
- Netting offsets the value of multiple positions or payments due to be exchanged between two or more parties.
- Exposure netting is achieved within a firm where it can find offsetting position in two or more currencies or other risk factors within various segments of the firm.
- Netting reduces a firm's cost and eases risk management as offsetting positions do not need to be individually hedged for risk exposures.
Understanding Exposure Netting
Exposure netting has the objective of reducing 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 challenging and costly to hedge each and every currency risk of a client individually when dealing with many international clients.
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, and the potential correlations between the different currencies to which it has exposure.
Exposure netting allows companies to manage their currency risk more holistically. If a company finds that correlation between exposure currencies is positive, the company would adopt a long-short strategy for exposure netting. 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 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.
Exposure netting can also be done to offset counterbalancing risks of a large portfolio or financial firm among its portfolios. As an enterprise risk management (ERM) strategy, if portfolio A for a bank is long 1,000 shares of Apple (AAPL) stock and another portfolio B is short 1,000 of Apple, the positions and the exposure to Apple price can be netted out at the managerial level.
Exposure netting usually refers to netting that happens within an organization among its various units, projects, or portfolios, making it a unilateral netting.
Netting with another party (e.g., in the case of a currency swap), would be considered bilateral, or even multilateral netting.
Exposure Netting Example
Assume Widget Co., located in Canada, has imported machinery from the United States and regularly exports to Europe. The company must 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 CHF 1 = USD 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.