Foreign Exchange Risk And Exposure

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

  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 (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.

  • The monitory/non-monitory methods:

    These 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:

    This method of translation uses the closing rate method for all items stated or replaced cost, realized values.

• 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 exposure is a comparatively straight forward concept but transaction and economic exposure are more complex.