Translation exposure is a type of foreign exchange risk faced by multinational corporations that have subsidiaries operating in another country. It is the risk that foreign exchange rate fluctuations will adversely affect the translation of the subsidiary’s assets and liabilities – denominated in foreign currency – into the home currency of the parent company when consolidating financial statements. Translation exposure is also called accounting exposure, or translation risk.
Translation exposure can affect any company that has assets or liabilities that are denominated in a foreign currency or any company that operates in a foreign marketplace that uses a currency other than the parent company’s home currency. The more assets or liabilities the company has that are denominated in a foreign currency, the greater the translation risk.
Ultimately, for financial reporting, the parent company will report its assets and liabilities in its home currency. So when the parent company is preparing its financial statements, it must include the assets and liabilities it has in other currencies. When valuing the foreign assets and liabilities for the purpose of financial reporting, all of the values will be translated into the home currency. Therefore foreign exchange rate fluctuations actually change the value of the parent company’s assets and liabilities. This is essentially the definition of accounting exposure.
Accounting Exposure Example
Here is a simplified example of accounting exposure. Assume the domestic division of a multinational company incurs a net operating loss of $3,000. But at the same time, a foreign subsidiary of the company made of profit of 3,000 units of foreign currency. At the time, the exchange rate between the dollar and the foreign currency is 1 to 1. So the foreign subsidiary’s profit exactly cancels out the domestic division’s loss.
Before the parent company consolidates its financial reports, the exchange rate between the dollar and the foreign currency changes. Now 1 unit of foreign currency is only worth $.50. Suddenly the profit of the foreign subsidiary is only worth $1,500 and it no longer cancels out the domestic division’s loss. Now the company as a whole must report a loss. This is a simplified example of translation exposure.
Hedging Translation Risk
A company with foreign operations can protect against translation exposure by hedging. The company can protect against the translation risk by purchasing foreign currency, by using currency swaps, by using currency futures, or by using a combination of these hedging techniques. Any one of these techniques can be used to fix the value of the foreign subsidiary’s assets and liabilities to protect against potential exchange rate fluctuations.