Managing Forex Risk: Hedging Technique - Netting

Whenever we buy or sell foreign goods and services while the payment or receipt date is not "now" but "future", we are exposed to foreign exchange transactional risk. The more transactions we have against foreign companies, the higher the risk is. This is especially crucial to Multi-National Company (MNC) when it involves intercompany buying and selling.

Why is there a risk? Risk simply means that we "do not know" or "do not able to forecast exactly" the forex rate in future. Whether it is higher or lower later, it is a risk now. By applying Netting, we can reduce the transactional risks. Let's see how it can help:-

For example, if company A has invoiced company B USD300 and at the same time company B has sold goods and invoiced company B for USD1,000, by netting off USD300 with company B's invoice of USD1,000, now the balance (the net receipt in this case) become USD700 to be received by company B from company A. In this way, the transactions of twice (payment from A to B AND from B to A) can be reduced to ONCE only (from A to pay B).

This can be further applied to MNCs when there are a lot of branches scattered worldwide and intercompany transactions are tremendous. By applying Netting, a local branch will only suffer ONE transaction risk for each of the foreign counterparties but not ALL foreign transactions. However, this depends on the frequency of payment as well: if payment is made monthly, then One transaction is exposed for each foreign counterparties; if payment is made half yearly, then One transaction is exposed for each counterparties every half a year.

There are other hedging techniques that can reduce or eliminate forex risk for a cost. However for internal transactions, Netting is still the best hedging technique to use as the net payment or receipt can still be rolled over to next cycle to knock off other transactions.