Question

What are the definitions of three types of foreign exchange risks (i.e., transaction, translation, and economic)? Are they all resulted from movements in the exchange rates or parity among currencies? Please briefly discuss the key factors in a corporation’s business model that affect one of these three types of foreign exchange risks (choose any one of transaction, translation, and economic

Answer 1

Transaction risk:

A transaction risk occurs when a value of future transactions, through known with certainty , is denominated in some currency other than the domestic currency. In such case the monetary value is fixed in terms of foreign currency at the time of agreement which is completed at a later date. All fixed value transactions such as receivables, payables, fixed price sale and purchase contracts etc. Are subject to transaction exposure. The transaction exposure looks at the effect of fluctuations in exchange rate on the transactions that have already been entered into and have been denominated in foreign currency.

Ex: Amount to be rec'd $100000 . Exchange rate changes from 1$= Rs50 to 1$= Rs 45

Loss due to the transaction exposure = $100000 ×(50-45) = Rs 500000

Translation exposure:

This is also called accounting exposure. It refers to and deals with the probability that the firm may suffer a deCrease in asset value due to devaluation of a foreign currency even if no foreign exchange transaction has occurred during the year. The transaction exposure occurs when the firms foreign balances are expressed in terms of the domestic currency. Change in exchange rates can therefore, alter the value of assets , liabilities , expenses and profit of foreign subsidiaries.

Ex : An asset denominated in foreign currency will lose value if the foreign currency declines In value.

Example: Firms have foreign operations like foreign branch, foreign subsidiary, foreign joint venture etc the financial statements of these operations are converted into local currency. For this purpose the firm follows GAAP. The net result if this process is gain or loss thereby effects the value of the firm.

Economic exposure.

It refers to the probability that the change in foreign exchange rate will effect the value of the firm.