Currency rate fluctuations influence the value of organization’s revenues, expenses, cash flows, assets, and liabilities.
Calculation of Currency rate fluctuations for Business organisations with foreign entities, are based on several transactions.
It includes exports, imports, borrowing, lending, portfolio investment and direct investment among other things. So an organisation need to know different types of Exchange Rate Risks.
Exchange Rate Risks or Exchange Rate Exposure is normally the risk result from fluctuations in the exchange rate
Firms must be extremely vigilant about Exchange Rate Risks as the exchange rate for foreign currencies fluctuates often these days.
The impact of variations on Exchange rate not only affect the organization that is directly involved in international commerce but also the domestic organization. Fluctuations on Exchange rate may affect operating cash flows and the home currency value of the firm’s assets and liabilities. Exchange rate is categorised into three for easy understanding.
Exchange Rate Risk Categories:
(a) Transaction Exposure
(b) Translation Exposure
(c) Economic Exposure
Transaction Exposure
Transaction exposure occurs when an organization has assets and liabilities that are contractually fixed in foreign currency and are expected to be liquidated in the near future. As a result, currency rate variations would affect loans, interest, dividends, and royalties paid to or received from foreign organizations. Transaction exposure is also created by any other receivables or payables, principal and interest repayments to foreign companies due within the current financial year.
The following are the some examples of transaction exposure
A foreign currency loan or interest is due to be paid or received soon.
A foreign currency receivable or due originating from the sale or purchase of goods and services is about to be liquidated shortly;
A dividend or royalty payment, for example, is to be made or received in foreign currency.
Translation Exposure
Translation Exposure arises from the fluctuating value of assets and liabilities as they show on the balance sheet and are not expected to be liquidated in the near future. This is often referred to as Consolidation Exposure or Balance Sheet Exposure. Translation exposure is purely nominal in nature because translation losses and benefits will vary depending on accounting principles. This viewpoint, however, is not universally shared. As a result, an attempt is made to quantify and control it. The primary distinction between transaction exposure and translation exposure is that the transaction exposure affects cash flows while the latter does not.
Economic Exposure
Economic exposure refers to elements that have an impact on cash flows but whose value is not contractually fixed, such as transaction exposure. It is also called Operating Exposure or operation Exposure.
The following are the best examples of economic exposure
- An agreement for the purchase or sale of items is under negotiation. Exchange rate variations may have an impact on the price of items being discussed.
- Tenders filed for contracts remain an economic exposure until the contract is awarded. The contract acquires will comes under transaction exposure once it is granted.
- If the money supply is constrained as a result of a depreciation of the home currency, the interest cost on working capital requirements may rise.
The exchange rate will have an impact on future revenues, costs, and hence operational profitability. The exchange rate will have an impact on future revenues, costs, and hence operational profitability. Operating exposure is also known as Strategic Exposure as these impacts are long-term and have an influence on organizations’ competitiveness,.
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