Question

Management of Forex Exposures. There are 3 major foreign exchange exposures, namely translation, transaction, and economic exposures.

PC. This if for 3-unit BA-343 International Banking special study, I need deeper explanation. Thanks

Answer 1

Foreign exchange exposure is the risk that arises when a firm has activites denominated in currencies other than its home currency. Such risks arise when the exchange rate of the domestic currency with those foreign currencies move in a direction detrimental to the firm. Becasue of these inherent risks associated with such activites, firms must manage their foreign exchange exposure.

Foreign exchange exposures are classified into three categories which, are explained below:

1) Transaction exposure arises when a firm enters into a contractual arrangement that involves a fixed cash outflow or inflow in a foreign currency withing the current accounting period.

Examples are a contract to import goods or a contract to export goods, which contract is denominated in a foreign currency.

The risk is that the exchange rate may move in a direction which will result in having to exchange more domestic currency for the desired payment in foreign currency or in having to receive less domestic currency in exchange for the foreign currency receipt.

Such risks can be hedged throught forward contracts, options, money market hedge, etc.

2) Translation exposure:

Such exposure arises when a global firm consolidates its financial statements (denominated in home currency) with that of its subsidiaries or branches (denominated in foreign currencies) so as to present the total picture in home currency. Such presentation obviously requires application of exchange rate to the values in foreign currencies so as to express or translate them in the domestic currency. The effect of the translation may be a gain or loss which is termed as translation gain or translation loss.

3) Economic exposure refer to risks arising from foreign exchange rate fluctuations that affect the value of a firm.

Value of a firm might be affected by change in the value of its assets and liabilities that are denominated in a foreign currency or through the impact that the exchange rate fluctuations would have on its competitive position. Changes in values of existing assets and liabilities are easily quantifiable when the exchange rate moves.

In contrast, as regards operating cash flows, the risk is to the firms competitive position. For instance, in the case of exports, if the currency of the importing country weakens, the existing price in terms of the domestic currency would go up resulting in adverse impact on the firm's competitive position in the importing country vis-a-vis the domestic firms or firms from other countries.