Definition of Foreign Exchange Risk

Foreign exchange risk concerns risks created by changes in foreign currency levels. An asset, liability or profit or cash flow stream, whether certain or not, is said to be exposed to exchange risk when a currency movement would change, for better or worse, its parent, or home, currency value. Exposure arises because currency movements may alter home currency values.

Forms of Currency Risks

Transaction exposure

Translation exposure.

Economic exposure.

Transaction Exposure

It arises because a payable or receivable is denominated in a foreign currency. The transaction exposure arises because the cost or proceeds (in home currency) of settlement of a future payment or receipt denominated in a currency other than the home currency may vary due to changes in exchange rate. Clearly transaction exposure is a cash flow exposure. It may be associated with trading flows (trade Drs and Crs) dividend flows or capital flows.

Translation Exposure

Translation exposure (sometimes also called accounting exposure) arises on the consolidation of foreign currency denominated assets, liabilities and profits in the process of preparing accounts. There are four basic translation methods:

The Current/Non-Current Method

This approach uses the traditional accounting distinction between current and long term items and translates the former at the closing rate and the latter at the historical rate.

The all-Current(Closing Rate) Method

This method merely translates all foreign currency denominated items at the closing rate of exchange. Accounting exposure is given simple by net assets or shareholder’s funds (sometimes called equity). This method has become increasingly popular over time and is now the major world wide method of translating foreign subsidiary’s balances sheet.

The monitory/Non-Monitory Methods

The monitory items are assets, liabilities or capital the amounts of which are fixed by contract in terms of the number of currency units regardless of changes in the value of money.

The Temporal Method

The temporal method of translation uses the closing rate method for all items stated or replaced cost, realized values. Market value or expected future value, and uses the historical cost rate for all items stated at historical cost.

Economic Exposure

Economic exposure arises because the present value of a stream of the expected future operating cash flow demonstrate in the home currency or in a foreign currency may very due to changed exchanged rates. Transaction and exposure are both cash flow exposure. Transaction exposure is a comparatively straight forward concept but transaction and economic exposure are more complex.

Economic exposure involves us in a analysis the effects of changing exchange rates on the following items.

Export sales, when margins and cash flow should change because devaluation should make exports more comparative

Domestic sales, when margins and cash flow should alter substantially in the import competitive sector

Pure domestic sales, where margins and cash flow should change in response to deflationary measures which frequently accompany devaluations

Cost of imported inputs which should rise in response to the devaluations.

Cost of domestic inputs, which may vary with exchange rate changes