Question

Discuss the causes of balance sheet or translation exposure to foreign exchange risk. Distinguish between balance sheet exposure and transaction exposure. Provide examples to illustrate your points.

Answer 1

Translation exposure is the risk of having changes in foreign exchange rates trigger losses on business transactions or balance sheet holdings. These losses can occur when a firm has assets, liabilities, equity, or revenue denominated in a foreign currency and needs to translate them back into its home currency. Translation is required by the accounting standards when preparing consolidated financial statements.

Translation exposure is most common in two situations. One is when a company has subsidiaries located in other countries, and the other is when a business engages in significant sales transactions in other countries. In both cases, there is a risk that an unfavorable change in the applicable exchange rates could cause a loss on the books of the reporting entity. These businesses can engage in hedging transactions to reduce their translation exposure.

Translation risk can lead to what appears to be a financial gain or loss that is not a result of a change in assets, but in the current value of the assets based on exchange rate fluctuations. For example, should a company be in possession of a facility located in Germany worth €1 million and the current dollar-to-euro exchange rate is 1:1, then the property would be reported as a $1 million asset. If the exchange rate changes, and the dollar-to-euro ratio becomes 1:2, the asset would be reported as having a value of $500,000. This would appear as a $500,000 loss on financial statements, even though the company is in possession of the exact same asset it had before.
A variety of mechanisms are in place that allow a company to use hedging to lower the risk created by translation exposure. One technique includes the purchasing of foreign currency, while others involve the use of currency futures or currency swaps.

Transaction exposure is the level of risk companies involved in international trade face, specifically, the risk that currency exchange rates will change after a company has already entered into financial obligations. A high level of exposure to fluctuating exchange rates can lead to major losses for firms.

This different range of risk between two methods is caused because of different form of FS translation method to reporting currency. The parent is lower exposed to currency risk by applying temporal method because all BS positions except monetary positions are translated upon historical exchange rate what exactly means that assets and liabilities values (other than monetary) in another currency had been frozen at same historical exchange rate. Also in P/L accounts average FX rate applies only to revenues and expenses related to monetary BS items. At most other PL positions also historical rate have been applied. This is not such case with the CR method. Another thing to distinguish is that by temporal method exchange gains and losses appear in parent PL instead of OCI such in case of CR method. In the event of high FX oscillation the parent net income may become more volatile upon temporal method.