Question

It is argued that the biggest challenge facing anyone is the recognition that an issue presents a problem that needs to be solved or at least managed. That said perhaps the key to getting to grips with currency exposure is to understand how it impacts the business. Discuss. (600 WORDS)

Answer 1

There are three types of exchange risks. These are: (1) Transaction risk, (ii) Translation or Consolidation risk, and (iii) Economic risk.

Unfavourable movement in the exchange rates results in foreign exchange risk or
currency risk. When a business enterprise has assets or liabilities denominated
in a foreign currency, or there are receivables or payables denominated in a
foreign currency, it has an exposure to that currency. An adverse movement in
the exchange rate can affect the business enterprise by:
• increasing its cash expenditures
• reducing its cash income
• reducing its reported profits
• increasing the value of its foreign currency liabilities
• reducing the reported value of its foreign assets
• damaging its competitive position in its domestic and foreign markets
Currency risk is directly affects business enterprises involved in overseas
operations. It also exists for any business that depends on foreign suppliers for
materials, equipment and services and competes against foreign producers in its
domestic market.
Foreign exchange/ currency exposure is the sensitivity of changes in the real
domestic currency value of operating income, assets or liabilities to unanticipated
changes in exchange rates. Currency risk is the likely or probable loss from such
currency exposure owing to adverse fluctuations in exchange rates. It is the risk
posed by adverse movements in exchange rates. When a company has assets
or liabilities denominated in a foreign currency, or contracts to receive or pay in a
foreign currency, it has an exposure to that currency.

Currency exposure is categorised depending upon which aspect of the
operations of an enterprise the said exposure affects.
Transaction exposure is related with foreign exchange loss or gain on
transactions which are already entered into and which are denominated in
foreign currency when exchange rate changes. Transaction exposure is
concerned with changes in the present cash flows of the firm where as
economic/operating exposure is concerned with future cash flows. Economic
exposure measures the change in the present value of the firm resulting from
any change in the future cash flows of the firm caused by an unexpected change
in the exchange rates. On the other hand translation exposure does not relate
with cash flows. Translation exposure arises from converting financial statements
expressed in foreign currencies into the home currency for the purpose of
preparation of consolidated financial statement of the parent company.