Question

DGP, Inc. sells 100,000 Gizmos to a retailer in Europe for €100,000 (Euros) on terms of 30 days from the date of invoice. The current rate of the EUR/USD is 1.3868; therefore, DGP, Inc. books the sale as an accounts receivable of US $138,680.

Instructions

1. Define and discuss the concepts of currency exposure risk, translation exposure, and economic exposure.
2. If the exchange rate of EUR/USD was 1.2868 in 30 days, what would be the impact on the company’s profit and loss at the time of the receipt of payment from the European customer? Include calculations.
   • What would be the economic exposure for the company? Include calculations.
   • What would be the translation exposure, if any? Include calculations.
3. What would be the impact on the company’s profit and loss at the time of the receipt of payment from the European customer if the exchange rate was EUR/USD 1.4868 in 30 days? Include calculations.
   • What would be the economic exposure for the company? Include calculations.
   • What would be the translation exposure, if any? Include calculations.
4. How could DGP, Inc. eliminate or reduce these exposure risks? Provide 2 hypothetical examples to support your answer.

Answer 1

a)

Currency Exposure Risk occurs due to the fluctuating currency exchange rates. As the exchange rates are constantly change, therefore there is an uncertainty associated if the business is carried out in a foreign currency. This risk is known as currency risk.

Translation Risk occurs for a company that has foreign subsidiaries. The assets of the subsidiary are purchased in the domestic currency of the subsidiary. As the exchange rate changes the value of the assets, etc. might be reported at a different value from period to period on the parent company's balance sheet. This uncertainty in the reporting value of the assets, equities, etc. is referred as translation risk. It is also called the accounting exposure.

Economic Exposure is a long term risk which affects the future cash flows. It is unexpected in nature and occurs due to changes in exchange rate. It is an operational risk and the cash flows are not realized but are anticipated.

b)

In 30 days if EUR/USD exchange rate = 1.2868

Amount to be received in EUR = 100,000

Equivalent USD amount = 1.2868 * 100,000 = $128,680

Amount booked under Account Receivable = $138,680

Based on this scenario, a Transaction Loss of ($138,600 - $128,600 ) = $10,000 will have to be recorded.

c)

There is no economic exposure to the company in this transaction as this is a short term horizon. Also, the deal has been agreed to and transaction is agreed to be made in Euros. The exposure in this case may be recorded as Transaction Exposure and the gain/loss will depend on the exchange rate on the day of transaction.

The transaction exposure exists on the entire sale amount of 100,000 Euros.

d)

There is no Translation exposure for the company. Translation exposure takes place if the company has a foreign subsidiary whose financial statements have to be reported as a part of the parent company's financial statements. This exposure occurs because of the fluctuations in the exchange rates of the currency due to which the reporting value may be changed while translating the currency.

e)

In 30 days if EUR/USD exchange rate = 1.4868

Amount to be received in EUR = 100,000

Equivalent USD amount = 1.4868 * 100,000 = $148,680

Amount booked under Account Receivable = $138,680

Based on this scenario, a Transaction Gain of ($148,600 - $138,600 ) = $10,000 be recorded.

f)

Strategies to eliminate/ reduce these risks:

1> Using a hedging strategy such as a forward contract, options or swaps.

example: company can enter a forward contract with a bank at EUR/USD = 1.3868

It is now assured of receiving $138,680 regardless of any changes in the exchange rate

2> Company can decide to accept payments in USD only.

example: If the company sells on the terms that it will accept payments in USD at the exchange rate prevailing on the day of the sale, it can be guaranteed to receive the fixed amount regardless of the exchange rate fluctuations.

If on the sale day, EUR/USD = 1.3868, and the company sells goods worth EUR 100,000. It translates to $138,680. As the company will accept payments in USD only it is guaranteed to receive that amount. The exchange risk is transferred to the buyer of goods.