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 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 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.
BREAKING DOWN Exposure Netting
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. 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 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.