Question

  What is the difference between foreign exchange risk arising from translation, transactions, and economic risks?

Answer 1

Transaction Exposure:-

A transaction exposure arises due to fluctuation in exchange rate between the time at which the contract is concluded in foreign currency and the time at which settlement is made. Transaction exposure is short term in nature, usually for a period less than one year. The credit purchase and sales, borrowing and lending denominated in foreign currencies, etc. are examples of transactions exposure. For example an Indian exporteris to receive payment in Pound in 30 days for export made today. His receipt is in Pound but Indian Rupee value is uncertain and it creates transaction exposure risk to exchange rate.

Translation Exposure:-

Translation known as an Accounting Exposure and also Balance Sheet Exposure exposure measures impact of changes in foreign currency exchange rate on the value of assets and liabilities. It indicates clearly that pre-existing assets and liabilities values change on account of change in foreign exchange rate. The assets and liabilities are consolidated in the parent firm’s balance sheet through translation of each and every asset and liabilities of the firm by using the exchange rate effective on the balance sheet date. The key difference between the transaction exposure and translation exposure is that the transaction exposure impacts the cash flow of the firm whereas translation has no effect on direct cash flows.

Economic Exposure:-

The economic exposure refers to the change in value of firm on account of change in foreign exchange rate. The intrinsic value of the firm is equal to the sum of the present values of future cash flows discounted at an appropriate rate of return. The firm’s economic exposure is translation exposure plus relevant transaction exposure at the time of the assessment of the total economic exposure of the firm. The economic exposure of a firm includes all the facets of a firm’s operations including the effects of changes in exchange rates on the customers, suppliers, competitors; and all other factors of environment in which firm is operating.