Concepts of Exposure
Currency Exposure Risk
The exposures caused by the unanticipated fluctuations in foreign currency rates and consequently, changes in the value of booked flow of finances are referred to as currency exposure risk. To overcome the currency exposure risks, businesses may use hedging technique or achieving efficiency in operational capacity of their businesses. These types of exposures are also referred to as cash flow exposures (Siddaiah, 2010; Eiteman, Stonehil, & Moffett, 2010).
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Translation Exposure Risk
Financial transactions of an organisation which are recorded in foreign currencies and are then converted into the local currency of an international business for presentation in the financial statements are subject to translation exposures. Worldwide, following techniques are used by multinationals for managing currency translation:
- Temporal method
- Current/noncurrent method
- Monetary/nonmonetary method
- Current rate method (Siddaiah, 2010; Eiteman, Stonehil, & Moffett, 2010).
Economic Exposure Risk
The changes arising in multinationals’ future cash flows due to the changes in foreign exchange rates are referred to as economic exposure risk. Economic exposure can further be classified as operating exposure and transaction exposure (Siddaiah, 2010; Eiteman, Stonehil, & Moffett, 2010).
2. If the exchange rate of EUR/USD was 1.2868 in 30 days then a loss of $10,000 i.e. the difference of $138,680 – $28,680 would be recorded in the profit and loss account as an exchange loss for the period related to business dealing with the European customer (Madura, 2012).
As DGP INC is a retail business operating in Europe and the Euro has shown appreciation against the US Dollar in the foreign currency market, it would directly effect DGP INC operations as it would be importing goods at a cheaper price. On the other hand, DGP receivables would be off lesser value as compared to their previous values. Such transactions effect entities’ economic activities (Apte., 2010).
Translation exposure exists in transactions as now the receivable equal to Euro 1 is worth $1.28, whereas, before it was worth $1.38 to 1 Euro.
3. If the exchange rate was EUR/USD 1.4868 in 30 days, a gain of $10,000 would be recorded in the profit and loss as an exchange gain, i.e. the difference $138,680 – $148,680. But here, the effects would be opposite as the scenario changed here as the Euro is depreciating against the Dollar. Now, DGP INC would be importing expensive goods and the receivable would be off greater value as it can be noted that the company would record a gain after translation, which would affect entities’ cash flowing activities (Das, 2013).
Translation exposure exists in the transaction as now the receivable equal to Euro 1 is worth $1.48, whereas before it was worth $1.38 to 1 Euro, but now the company would purchase less as now the Euro is worth less compared to US Dollar.
4. Company should use short hedge technique in order to reduce such risk by locking the amount of sale price with the buyer so that if there are any increase or decrease in exchange rates, it would not affect the sale price of the entity. To simplify, this hedging techniques allow a business to base its position according to the environment in the market on short term basis (Giddy, 2013).
For example, to hedge funds of DGP INC during unfavourable market conditions, it may opt to go for locking transactions with clients in the international markets. Let us suppose, if DGP engages in business with ABC business across continent, than it would go for locking the amount of sale price with ABC.
It is important to notice here that DGP should be efficient enough to gauge the market environment and anticipate a translation value that suits both parties and does not hurt their interest. Now, even if there are any unexpected changes in the exchange rate, the deal between DGP and ABC will stand as it is and the change in the exchange rate wouldn’t affect the sale price of the entity.
To provide another example of avoiding exposure risks is the money market hedging technique for DGP future foreign exchange deals. Taking ABC INC as a client, DGP INC would sell its products to its client by borrowing the same value of sale receipts from a bank in ABC INC’s local currency and then pay out ABC INC’s local currency denominated amount for the purchased products. The cost involved in this transaction is the interest rate on ABC INC’s local currency loan, which is somehow less costly than the other hedging techniques.
Apte. (2010). International Financial Management. New Delhi: Tata McGraw-Hill.
Das, D. (2013). International Finance: Contemporary Issues. London: Routledge.
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Eiteman, D., Stonehil, A., & Moffett, M. (2010). Multinational Business Finance 12th Ed. New Jersey: Prentice Hall.
Giddy, I. H. (2013, June 25). Corporate Hedging: Tools and Techniques. Retrieved from: http://pages.stern.nyu.edu/~igiddy/articles/hedging_techniques.html
Madura, J. (2012). International Financial Management, Abridged Edition. NY: Cengage.
Siddaiah, T. (2010). International Financial Management. New Delhi: Pearson Education India.