Understanding Foreign Exchange Risk Exposure: Types and Examples
Types of Foreign Exchange Risk Exposure
- Types of foreign exchange risk exposure
Transaction Risk
Transaction Risk is the risk of an exchange rate changing between the transaction date and the subsequent settlement date. Thus, it is the gain or loss arising on conversion.
This type of risk is primarily associated with imports and exports. If a company exports goods on credit, then it has a figure for debtors in its accounts. The amount it will finally receive depends on the foreign exchange movement from the transaction date to the settlement date.
For example: Suppose there is a three-day interval between a transaction’s execution and settlement. The company is receiving payment in GBP, which they must repatriate into USD – their local currency. Transaction risk is the risk that the GBP-USD exchange rate will decrease during this three-day period.
Economic Risk
Economic Risk is the currency risk that results from exchange rate fluctuations affecting the pricing of products, the cost of inputs, and income from foreign assets.
For example, let’s assume American Company XYZ invests $1,000,000 in a manufacturing plant in the Congo. Aside from the business risk associated with making the plant profitable, Company XYZ is exposed to economic risk. The political environment could shift quickly, perhaps prompting the Congolese government to seize the plant or significantly change laws that affect Company XYZ’s ability to operate the plant. Likewise, hyperinflation could make it impossible to pay workers, or exchange rate circumstances could make it unprofitable to move profits out of the country.
Another example (presented in class by Professor Ali): Let’s assume that one visits London for a month to do shopping there. If during this time the value of GBP goes up, then shopping becomes more expensive for this person.
Translation Exposure
Translation Exposure is the currency risk that results when a firm translates financial statements denominated in a foreign currency into the functional currency of the parent firm, as part of consolidating international financial results.
Here is a simplified example of accounting exposure. Assume the domestic division of a multinational company incurs a net operating loss of $3,000. But at the same time, a foreign subsidiary of the company made a profit of 3,000 units of foreign currency. At the time, the exchange rate between the dollar and the foreign currency is 1 to 1. So the foreign subsidiary’s profit exactly cancels out the domestic division’s loss.
Before the parent company consolidates its financial reports, the exchange rate between the dollar and the foreign currency changes. Now 1 unit of foreign currency is only worth $.50. Suddenly, the profit of the foreign subsidiary is only worth $1,500, and it no longer cancels out the domestic division’s loss. Now the company as a whole must report a loss. This is a simplified example of translation exposure.
Example: In class, Professor Ali presented a “paper” or “virtual” example of gain or loss in a following situation: Let’s assume that we own a villa in Florida that costs $100 million. Next year, the value for real estate in Florida goes down by 10%, and the villa now costs $90 million. Thus, if we plan to sell the villa, the 10% loss is our “paper” loss. Likewise, if real estate value goes up, we become richer on “paper.”