Growth of international business has led to an increasing exposure to foreign exchange risk for many companies. Foreign exchange dealing results in three major kinds of exposure including transaction exposure, economic exposure and translation exposure. Many companies manage their foreign exchange exposure by hedging it using complex financial instruments. Hedging involves reducing the uncertainty related to cash flows resulting from positive foreign exchange exposure. One way to hedge foreign exchange risk is to buy or sell currency at a predetermined future date and price.
Foreign exchange dealing results in three major kinds of exposure including transaction exposure, economic exposure and translation exposure.
The transaction exposure component of the foreign exchange rates is also referred to as a short-term economic exposure. This relates to the risk attached to specific contracts in which the company has already entered that result in foreign exchange exposures.
A company may have a transaction exposure if it is either on the buy side or sell side of a business transaction. Any transaction that leads to an inflow or outflow of a foreign currency results in a transaction exposure. For example, Company A located in the United States has a contract for purchasing raw material from Company B located in the United Kingdom for the next two years at a product price fixed today.
In this case, Company A is the foreign exchange payer and is exposed to a transaction risk from movements in the pound rate relative to dollar. If the pound sterling depreciates, Company A has to make a smaller payment in dollar terms, but if the pound appreciates, Company A has to pay a larger amount in dollar terms leading to foreign currency exposure.
Economic exposure is a long-term effect of the transaction exposure. If a firm is continuously affected by an unavoidable exposure to foreign exchange over the long-term, it is said to have an economic exposure.
Exposure to foreign exchange results in an impact on the market value of the company as the risk is inherent to the company and impacts its profitability over the years. A beer manufacturer in Argentina that has its market concentration in the United States is continuously exposed to the movements in the dollar rate and is said to have an economic foreign exchange exposure.
Translation exposure of foreign exchange is of an accounting nature and is related to a gain or loss arising from the conversion or translation of the financial statements of a subsidiary located in another country. A company such as General Motors may sell cars in about 200 countries and manufacture those cars in as many as 50 different countries.
A company with subsidiaries or operations in foreign countries is exposed to translation risk. At the end of the financial year the company is required to report all its combined operations in the domestic currency terms leading to a loss or gain resulting from the movement in various foreign currencies.