Exchange Risk

Managing

Foreign Exchange Risk

International business are exposed to the exchange risk that may affect the firm. There are 3  types of foreign-exchange exposure confronting international firms and it is transaction, translation and economic

Transaction Exposure

A firm faces transaction financial when the financial benefits and costs of an international transaction can be affected by exchange rate movements that occur after the firm is legally obligated to complete the transaction. Many  international business involved transaction exposure including; purchase of goods, services, or assets, sales of goods, services, or assets, extension of credit, borrowing of credit. In most international transactions, one of the parties has to bear transaction exposure. There are several options for responding to this transaction exposure which is Go naked, Buy forward currency, Buy currency future, Buy currency option and Acquire offsetting asset that explain as follow;

Table

Translation Exposure

Translation exposure is the impact on the firm’s consolidated financial statements of fluctuations in exchange rates that change the value of foreign subsidiaries as measured in the parent’s currency. If the exchange rates were fixed, translation exposure would not exist. Translation exposure develops from the need to consolidate financial statements into a common currency, it is often called accounting exposure.

Financial officers can reduce their firm’s translation exposure through the use of balance sheet hedge. A balance sheet hedge is created when an international firm matches its assets denominated a given currency with its liabilities denominated in that same currency. Tis balance occurs on a currency-by-currency basis, not on a subsidiary-by-subsidiary basis. Some experts believe managers should ignore translation exposure and instead focus on reducing transaction exposure, arguing that transaction exposure can produce true cash losses to the firm, whereas translation exposure produces only paper, or accounting, losses. Other experts disagree, stating that translation exposure should not be ignored. For instance, firms forced to take write-downs of the value of their foreign subsidiaries may trigger default ckauses in their loan contracts if their debt-to-equity ratios rise too high.

Economic Exposure

 Economic exposure is the impact on the value of a firm’s operations of unanticipated exchange rate changes. From a strategic perspective, the threat of the economic exposure deserves close attention from the firm’s highest policy makers because it affects virtually every area of operations, including global production, marketing and financial planning. Unanticipated exchange rate fluctuations may affect a firm’s overall sales and profitability in numerous markets.

One approach firms can use to address the problem of economic exposure is to utilize an operational hedge or natural hedge by trying to match their revenues in a given currency with an equivalent flow of costs. An important element of managing economic exposure is analyzing likely changes in exchanges rates.

The theory of purchasing power parity, for example, provides guidance regarding long-term trends in exchange rates between countries. In the short term forward exchange rates have been found to be unbiased predictors of future spot exchange rates, because of the importance of interest arbitrage in establishing equilibrium exchange rates, experts also may forecasts countries’ monetary policies ti predict future currency values.

Balance of payments performance also is useful because it provides insights into whether a country’s industries are remaining competitive in world markets and whether foreigners’ short-term claims on a country are increasing. Prospects for inflation also carefully assessed because inflation can affect a country’s export prospects, demand for imports and future interests rates.