Final answer:
A firm can manage its transaction exposure primarily by using financial instruments such as forwards and options, which allow for the locking in of exchange rates and mitigating the impact of currency fluctuations.
Step-by-step explanation:
The question focuses on strategies a firm may use to manage its transaction exposure, which is the risk of foreign exchange rate fluctuations affecting the value of a company's financial transactions. The options provided are:
- Using financial instruments such as forwards and options
- Diversifying the markets to which the firm sells its products
- Following a flexible sourcing policy
- Sourcing inputs from low-cost production sites
- Building a moat for its products by investing in R&D and product differentiation
Out of these, using financial instruments like forwards and options is a direct strategy for managing transaction exposure. This is because they allow firms to lock in exchange rates for future transactions, mitigating the risk associated with currency fluctuations. Diversifying markets and sourcing policies may help a firm mitigate broader financial risks but are less targeted at managing transaction exposure specifically.