Question

Describe the types of exchange rate risk for companies operating in brazil

Answer 1

Brazil changed its foreign exchange system in 1999 from a fixed exchange system to a floating exchange system. This change increased the foreign exchange exposure of companies in Brazil.

There are primarily 3 types of foreign exchange risks facing companies in Brazil, They are :

1. Transaction risk

This is the risk arising on short-term foreign currency transactions that the actual income or cost may be different from the income or cost expected when the transaction was agreed.  Transaction risk affects cash flows and for this reason most companies choose to hedge or protect themselves against transaction risk.

2. Translation risk

This risk arises on consolidation of financial statements prior to reporting financial results and for this reason is also known as accounting exposure. Translation risk does not involve cash flows and does not directly affect shareholder wealth. However, shareholder perception may be affected by the changing values of assets and liabilities, and so a company may choose to hedge translation risk through, for example, matching the currency of assets and liabilities (e.g. a Dollar-denominated asset financed by a Dollar-denominated loan or borrowing).

3. Economic risk

Economic risk could be defined as the risk of the present value of a company’s expected future cash flows being affected by exchange rate movements over time. It is difficult to measure economic risk, although its effects can be described, and it is also difficult to hedge against it.