Tram Toy Ltd is a company which distributes and sells a popular toy train. The company, which is based in Australia, imports trains from the USA which it packages and sells in New Zealand and larger countries in the Far East. The company is also considering establishing a subsidiary in South Africa which would buy products from Tram Toy Ltd and sell within Africa.

Tram Toy Ltd reports its results in its home currency. The company pays for its purchases from the USA in US dollars, but receives payment for the goods which it sells in Australia and the Far East in local currency. All transactions carried out with the subsidiary in South Africa would be in US dollars. The company generally takes 6 weeks to pay its supplier in the USA and receives payment from debtors within 3 months.

Over the last few years the company has found that sales have been quite predictable and it has been possible to plan sales levels and purchases of goods in advance. However, there is increasing competition from companies in the Far East, which may make this more difficult in the future.

Required:

(a) The company is currently considering whether the foreign currency exposure could be managed more efficiently. Describe the following types of foreign currency exposure, giving examples of how they could impact Tram Toy Ltd, now and in the future: (12 marks)

(i)Economic risk

(ii) Translation risk

(iii)Transaction risk

(b) Describe the following approaches to managing or hedging transaction exposure and the disadvantages and advantages of each method: (12 marks)

(i)Leading and lagging

(ii) Matching

(iii)Forward exchange contracts

(iv)Currency options