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The Three Types of Foreign Currency Exposure

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The Three Types of Foreign Currency Exposure

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  • July 2012
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Items and/or transactions are said to be exposed if the following two conditions are met: they are denominated in foreign currencies and
they are translated at the current exchange rate.

The three types of foreign currency exposure are; Translation, Transaction and economic exposures

Translation exposure
Translation exposure measures the effect of an exchange rate change on published financial statements of a firm. Translation exposure results when a multinational corporation (MNC) translates each subsidiary’s financial data to its home currency for consolidated financial reporting. Translation exposure does not directly affect cash flows, but some firms are concerned about it because of its potential impact on reported consolidated earnings.

An MNC may attempt to avoid translation exposure by matching its foreign liabilities with its foreign assets. To hedge translation exposure, forward or futures contracts can be used. Specifically, an MNC may sell the currency that its foreign subsidiary receive as earnings forward, thus creating an offsetting cash outflow in that currency.

For example, a U.S.-based MNC that is concerned about the translated value of its British earnings may enter a one-year forward contract to sell pounds. If the pound depreciates during the fiscal year, the gain generated from the forward contract position will help to offset the translation loss.

Transaction exposure
Transaction exposure measures the effect of an exchange-rate change on outstanding obligations which existed before exchange rates changed, but were settled after the exchange-rate change.

When a firm has accounts receivable in foreign exchange at some time in the future, it is exposed to transactions exposure i.e. losses or gains due to unexpected changes in the exchange rate.

The payoff from an unhedged long position, say accounts receivable in 90 days in USD. The expected exchange rate (ZWD price of the USD) in 90 days is given by F90,

In...

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