Foreign Exchange Exposure

 

 Foreign Exchange Exposure
Definition: Foreign Exchange Exposure refers to the risk associated with the foreign
exchange rates that change frequently and can have an adverse effect on the financial
transactions denominated in some foreign currency rather than the domestic currency of the
company.
In other words, the firm’s risk that its future cash flows get affected by the change in the
value of the foreign currency, in which it has maintained its books of accounts (balance
sheet), due to the volatility of the foreign exchange rates is termed as foreign exchange
exposure.
It is not only those firms who directly make the financial transactions in the foreign currency
denominations faces the risk of foreign exposure, but also, the other firms who are indirectly
related to the foreign currency is exposed to foreign currency risk.
For example, if Indian company is competing against the products imported from China and
if the Chinese yuan per Indian rupee falls, then the importers enjoy decreased cost advantage
over the Indian company. This shows, that the companies not having any direct link to the
forex do get affected by the change in the foreign currency.
Types of Foreign Exchange Exposure

1. Transaction Exposure
2. Operating Exposure
3. Translation Exposure

Out of these three risks, the first two risks, i.e. transaction risk and the operating risk are
called “cash flow exposure” or “economic exposure”, while the translation risk is called the
“accounting exposure”.
Transaction Exposure
Definition: The Transaction Exposure is a kind of foreign exchange risk involved in the
international trade wherein the cross-currency transactions (multiple currencies) are involved.
In other words, a risk faced by the company that while dealing in the international trade, the
currency exchange rates may change before making the final settlement, is termed as a
transaction exposure.
If the Indian exporter has the receivable of $5,00,00, due five months hence, but in the
meanwhile the dollar depreciates relative to the rupee, then the exporter will suffer the cash
loss. But however, in the case of a payable of the same amount, the exporter gains if the
dollar depreciates relative to the rupee.
Thus, once the cross-currency contract has been agreed upon by the firms located in two
different countries for the specific amount of goods and money, the contract value may
change with the fluctuations in the foreign exchange rates. This risk of change in the
exchange rates is called the transaction exposure.
The greater the time gap between the agreement and the final settlement, the higher is the risk
associated with the change in the foreign exchange rates. However, the companies could save
themselves against the transaction exposure through hedging techniques.
Operating Exposure
Definition: The Operating Exposure refers to the extent to which the firm’s future cash
flows gets affected due to the change in the foreign exchange rates along with the price
changes. In other words, a risk that firm’s revenue will be adversely affected due to the
substantial change in the exchange rate and the inflation rate is called as operating exposure.
Operating Exposure, like transaction exposure, also involves the actual or potential gain or
loss, but the latter is specific in nature and deals with a particular transaction of the firm,
while the former deals with certain macro level exposure wherein not only the firm under
concern gets affected but rather the whole industry observes the change with the change in
the exchange rates and the inflation rate. Thus, with operating exposure, the entire economy
is exposed to the foreign exchange risk.
Since, operating exposure is much broader in nature, and relates to the entire investment of
the firm so with the change in the exchange rates the overall value of the firm gets altered.
The firm’s value is comprised of the operating cash flows and the total assets the firm
possesses.
It is quite difficult to identify operating risk, as the cash flows largely depends on the cost of
firm’s inputs and the prices of its outputs which gets altered significantly with the change in
the foreign exchange rates. Also, such exposure relates to the unseen challenges from the

competitors, entry barriers, etc., which are subjective in nature and are interpreted differently
by different experts. Thus, operating exposure influences the competitive position of the firm
substantially.
Translation Exposure
Definition: The Translation Exposure or Accounting Exposure is the risk of loss suffered
when stock, revenue, assets or liabilities denominated in foreign currency changes with the
movement of the foreign exchange rates.
In other words, the translation exposure stems from the requirement of converting the
subsidiary’s assets and liabilities (operating in another country) denominated in foreign
currency in the home currency of the parent company, at the time of preparing the
consolidated profit and loss statement and the balance sheet. Thus, any change in the foreign
exchange rate will have a considerable impact on the financial statements.
In translating the items denominated in foreign currency in the domestic currency, an
accountant encounters two issues:
1. Whether the financial statement items denominated in foreign currency are converted
at the current exchange rate or at the rate which was prevailing at the time the
transaction occurred (historical exchange rate)?
2. Whether the profit or loss that arises from the rate adjustments be taken into the
current period profit and loss statement or be postponed?
If there is any change in the exchange rate over the previous accounting period, then the
translation of the items denominated in the foreign currency will result in foreign exchange
gains or losses, except when there is a tax implication on these items.
The translation exposure is concerned with the recorded profits and the balance sheet values
and does not affect the overall value of the firm. Since the gains or losses suffered due to the
translation of financial items has no significant impact on the stock prices of the firm. And
the investors do believe that such risk can be diversified and hence does not demand any
extra premium for it.