Question

In cross border trades,it is likely to make (incur)foreign exchange gains (losses)due to foreign currency fluctuation . How would you describe this scenario?

Answer 1

Foreign Iexchange Irisk Irefers Ito Ithe Ilosses Ithat Ian Iinternational Ifinancial Itransaction Imay Iincur Idue Ito Icurrency Ifluctuations. IAlso Iknown Ias Icurrency Irisk, IFX Irisk Iand Iexchange-rate Irisk, Iit Idescribes Ithe Ipossibility Ithat Ian Iinvestment’s Ivalue Imay Idecrease Idue Ito Ichanges Iin Ithe Irelative Ivalue Iof Ithe Iinvolved Icurrencies. IInvestors Imay Iexperience Ijurisdiction Irisk Iin Ithe Iform Iof Iforeign Iexchange Irisk.

A Iforeign Iexchange Igain/loss Ioccurs Iwhen Ia Iperson Isells Igoods Iand Iservices Iin Ia Iforeign Icurrency. IThe Ivalue Iof Ithe Iforeign Icurrency, Iwhen Iconverted Ito Ithe Ilocal Icurrency Iof Ithe Iseller, Iwill Ivary Idepending Ion Ithe Iprevailing Iexchange Irate. IIf Ithe Ivalue Iof Ithe Icurrency Iincreases Iafter Ithe Iconversion, Ithe Iseller Iwill Ihave Imade Ia Iforeign Icurrency Igain.

However, Iif Ithe Ivalue Iof Ithe Icurrency Ideclines Iafter Ithe Iconversion, Ithe Iseller Iwill Ihave Iincurred Ia Iforeign Iexchange Iloss. IIf Iit Iis Iimpossible Ito Icalculate Ithe Icurrent Iexchange Irate Iat Ithe Iexact Itime Iwhen Ithe Itransaction Iis Irecognized, Ithe Inext Iavailable Iexchange Irate Ican Ibe Iused Ito Icalculate Ithe Iconversion.

For Iinstance, Ia IBelgian Imanufacturer Ithat Ibuys Icomponents Ifrom Ian IAsian Iprovider. IEach Itime Ithey Imake Ia Ipurchase, Ithey Iagree Ion Ia Iprice Iin IUS Idollar Iwith Itheir Isupplier. IHowever, Ithat Itransaction Iwill Ibe Irecorded Iin Ithe Icompany’s Iincome Istatement Iin Itheir Ifunctional Icurrency I– Iin Ithis Icase, Ithe Ieuro. IMoreover, Ithe Isame Irules Iapply Ito Iexporters; Itheir Isales Iin Iforeign Icurrencies Iare Iregistered Iin Ieuros Iin Ithe Icompany’s Ibooks.

Bearing Iin Imind Ithat Ithe Iexchange Irate Imoves Icontinuously I24/5, Iwhen Ithere Iis Ia Isignificant Ilapse Iof Itime Ibetween Ithe Isale Ior Ipurchase Iagreement Iand Ithe Ipayment Idate, Ithe Ivalue Iof Ithe Icompany’s Iaccount Ipayables Iand Iaccount Ireceivables Iin Itheir Ifunctional Icurrency Ifluctuates Iaccordingly. IThis Ifluctuation Ioccurs Ifrom Ithe Imoment Ithe Iinvoice Iis Isent Ior Ireceived Iuntil Iit Iis Isettled.

The Idifferences Iin Ithe Ivalue Iof Ithose Imonetary Iassets Iand Iliabilities Iare Iregistered Ias IFX Igains Iand Ilosses, Iwhich Iare Ilikely Ito Ihave Ia Isevere Iimpact Ion Ithe Icompany’s Iprofit Imargins.

In Iorder Ito Iminimise IFX Igains Iand Ilosses Iin Itheir Ifinancial Istatements, Isome Icompanies Iusing IFX Iderivatives Ito Ihedge Icurrency Irisks Iimplement Ihedge Iaccounting Imethods.

There Iare Ithree Itypes Iof Iforeign Iexchange Irisk:

1. Transaction Irisk: IThis Iis Ithe Irisk Ithat Ia Icompany Ifaces Iwhen Iit's Ibuying Ia Iproduct Ifrom Ia Icompany Ilocated Iin Ianother Icountry. IThe Iprice Iof Ithe Iproduct Iwill Ibe Idenominated Iin Ithe Iselling Icompany's Icurrency. IIf Ithe Iselling Icompany's Icurrency Iwere Ito Iappreciate Iversus Ithe Ibuying Icompany's Icurrency Ithen Ithe Icompany Idoing Ithe Ibuying Iwill Ihave Ito Imake Ia Ilarger Ipayment Iin Iits Ibase Icurrency Ito Imeet Ithe Icontracted Iprice.
2. Translation Irisk: IA Iparent Icompany Iowning Ia Isubsidiary Iin Ianother Icountry Icould Iface Ilosses Iwhen Ithe Isubsidiary's Ifinancial Istatements, Iwhich Iwill Ibe Idenominated Iin Ithat Icountry's Icurrency, Ihave Ito Ibe Itranslated Iback Ito Ithe Iparent Icompany's Icurrency.
3. Economic Irisk: IAlso Icalled Iforecast Irisk, Irefers Ito Iwhen Ia Icompany’s Imarket Ivalue Iis Icontinuously Iimpacted Iby Ian Iunavoidable Iexposure Ito Icurrency Ifluctuations.

Realized Iand IUnrealized IForeign IExchange IGain/Loss

1. IRealized IGains/Losses

Realized Igains Ior Ilosses Iare Ithe Igains Ior Ilosses Ithat Ihave Ibeen Icompleted. IIt Imeans Ithat Ithe Icustomer Ihas Ialready Isettled Ithe Iinvoice Iprior Ito Ithe Iclose Iof Ithe Iaccounting Iperiod.

For Iexample, Iassume Ithat Ia Icustomer Ipurchased Iitems Iworth I€1,000 Ifrom Ia IUS Iseller, Iand Ithe Iinvoice Iis Ivalued Iat I$1,100 Iat Ithe Iinvoice Idate. IThe Icustomer Isettles Ithe Iinvoice I15 Idays Iafter Ithe Idate Ithe Iinvoice Iwas Isent, Iand Ithe Iinvoice Iis Ivalued Iat I$1,200 Iwhen Iconverted Ito IUS Idollars Iat Ithe Icurrent Iexchange Irate.

This Imeans Ithat Ithe Iseller Iwill Ihave Ia Irealized Iforeign Iexchange Igain Iof I$100 I($1,200–$1,100). IThe Iforeign Icurrency Igain Iis Irecorded Iin Ithe Iincome Isection Iof Ithe Iincome Istatement.

2. IUnrealized IGains/Losses

Unrealized Igains Ior Ilosses Iare Ithe Igains Ior Ilosses Ithat Ithe Iseller Iexpects Ito Iearn Iwhen Ithe Iinvoice Iis Isettled, Ibut Ithe Icustomer Ihas Ifailed Ito Ipay Ithe Iinvoice Iby Ithe Iclose Iof Ithe Iaccounting Iperiod. IThe Iseller Icalculates Ithe Igains Ior Iloss Ithat Iwould Ihave Ibeen Isustained Iif Ithe Icustomer Ipaid Ithe Iinvoice Iat Ithe Iend Iof Ithe Iaccounting Iperiod.

For Iexample, Iif Ia Iseller Isends Ian Iinvoice Iworth I€1,000, Ithe Iinvoice Iwill Ibe Ivalued Iat I$1,100 Ias Iat Ithe Iinvoice Idate. IAssume Ithat Ithe Icustomer Ifails Ito Ipay Ithe Iinvoice Ias Iof Ithe Ilast Iday Iof Ithe Iaccounting Iperiod, Iand Ithe Iinvoice Iis Ivalued Iat I$1,000 Iat Ithis Itime.

When Ipreparing Ithe Ifinancial Istatements Ifor Ithe Iperiod, Ithe Itransaction Iwill Ibe Irecorded Ias Ian Iunrealized Iloss Iof I$100 Isince Ithe Iactual Ipayment Iis Iyet Ito Ibe Ireceived. IThe Iunrealized Igains Ior Ilosses Iare Irecorded Iin Ithe Ibalance Isheet Iunder Ithe Iowner’s Iequity Isection.

Currency Irisk Iis Ithe Ifinancial Irisk Ithat Iarises Ifrom Ipotential Ichanges Iin Ithe Iexchange Irate Iof Ione Icurrency Iin Irelation Ito Ianother. IAnd Iit's Inot Ijust Ithose Itrading Iin Ithe Iforeign Iexchange Imarkets Ithat Iare Iaffected. IAdverse Icurrency Imovements Ican Ioften Icrush Ithe Ireturns Iof Ia Iportfolio Iwith Iheavy Iinternational Iexposure, Ior Idiminish Ithe Ireturns Iof Ian Iotherwise Iprosperous Iinternational Ibusiness Iventure. ICompanies Ithat Iconduct Ibusiness Iacross Iborders Iare Iexposed Ito Icurrency Irisk Iwhen Iincome Iearned Iabroad Iis Iconverted Iinto Ithe Imoney Iof Ithe Idomestic Icountry, Iand Iwhen Ipayables Iare Iconverted Ifrom Ithe Idomestic Icurrency Ito Ithe Iforeign Icurrency.

The Icurrency Iswap Imarket Iis Ione Iway Ito Ihedge Ithat Irisk. ICurrency Iswaps Inot Ionly Ihedge Iagainst Irisk Iexposure Iassociated Iwith Iexchange Irate Ifluctuations, Ibut Ithey Ialso Iensure Ireceipt Iof Iforeign Imonies Iand Iachieve Ibetter Ilending Irates.