The degree to which a company is affected by currency fluctuations is referred to as foreign exchange exposure. (Shapiro, 2003). Foreign Exchange exposure can be divided into two main types-Accounting exposure and Economic exposure. Transaction reflects the firm’s risk to exchange rate movements regarding its balance sheet assets and liabilities... The terms of these transactions are established and settled at a given time period and their exposure can easily be measured by accounting systems (Mullem & Verschoor, 2005). The implicit or explicit contractual agreements have to be taken into account as well as when measuring the overall exchange rate exposure. (Mullem & Verschoor, 2005). The last component of a company’s exposure to currency fluctuations is called competitive or economic exposure. As exchange rate variations affect the relative prices of goods sold in different countries, they affect a firm’s competitive position and indirectly influence its economic environment and future growth possibilities (Mullem & Verschoor, 2005). Although a firm may hedge its foreign exchange contracts, limiting its transaction exposure, economic exposure is difficult to estimate and further, hedge. Economic exposure arises because future profits from operating as importer or exporter depend on exchange rates, and due to its nature, this type of exposure is difficult to mute. (Faff & Iorio 2001, Mullem & Verschoor). (Mullem & Verschoor, 2005). However, there is greater complexity between the relationship between exchange rate fluctuations and competitiveness and this leads to difficulty in correctly estimating economic exposure and hence hedging it efficiently (Mullem & Verschoor, 2005). Firms that do business abroad must be ready to account for changes in exchange rates that lead to variability in their cash flows. (Solt & Lee, 2001). Transaction exposure reflects the risk that exchange rates change between the time a transaction is recorded and the time actual receipt of cash or payment of cash is made. (Solt & Lee, 2001). Due to its short-term nature futures and forwards can be used to hedge transaction exposure and thereby eliminate its influence on the value of a firm. (Solt & Lee, 2001). Economic exposure on the other hand is the long-term effect of exchange rate changes on the future cash flows and thereby on stock returns. (Solt & Lee, 2001). The table below summarises the different types of exchange rate risk faced by firms: Comparison of translation, transaction and operating Exposure Translation exposure Operating exposure
Fluctuations in income statements items and book values of balance sheet assets and liabilities that are caused by exchange rate fluctuations. Subsequent exchange rate gains and losses are determined by accounting rules and reflect nominal gains and losses only. The measurement of accounting exposure is retrospective that is it is applied to prior period accounts. Its only impact is on liability and assets that already exist. Movements in the amount of future operating cash flows occurring as a result of fluctuations in exchange rates. Subsequent exchange translation gains and losses are determined by changes in the firm’s future competitive position and are real. The measurement of operating exposure is prospective That is it is based on future periods unlike the retrospective measurement applied to translation exposure. The impacts of operating exposure are more serious than those of translation exposure as it affects revenues and costs associated with future sales. Taken from Shapiro (2003).
N.B: Transaction exposure is common to both translation and operating exposure. That is why I have not mentioned it in the table. Measuring Foreign Exchange Exposure
Shapiro identifies four methods of measuring currency translation gains and losses or translation exposure. They include: the current/concurrent method, the...