Question

Distinguish between the following types of foreign exchange exposure:

1. Transaction exposure
2. Economic exposure
3. Translation exposure

Given 1 example for each.

Answer 1

Transaction exposure occurs when companies buy or sell in different currencies. It occurs when there is international trade .There is actual cash outflow or inflow. Hence there is actual profit or loss.
Example. If a US based company buys a product from India and the payment is to be made in Indian Rupee. Then the entire risk of currency exchange lies with the US company if the product is sold in terms of Rupee.

Economic exposure is the long term impact of cash flows due to economic issues in a country. It is also known as Operating exposure . Economic exposure is difficult to predict and hedging against it is difficult.
Example:Due to economic factors if the US GDP continuously increases then the US currency appreciates. This puts foreign companies in US at higher exchange rate risk.

Translation exposure occurs due to consolidation of balance sheet of subsidiaries. There is currency exposure of assets and liabilities but these are notional losses or gains and not actual gains or losses. This is also called accounting exposure.This happens with Multinational companies who have their subsidiaries in foreign countries. Any fluctuation in exchange rate can appreciate or depreciate the value of assets in foreign country.
Example: If a German company has a US subsidiary. If the Dollar appreciates with respect to Euro . The value of assets and cash in terms of Euro will depreciate leading to translation losses.