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Translation Exposure

See Also:
Transaction Exposure
Currency Swap
Exchange Traded Funds
Hedge Funds
Fixed Income Securities

Translation Exposure

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. You can also call translation exposure either 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. Simply put, the more assets or liabilities the company has that are denominated in a foreign currency, the greater the translation risk.

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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, translate all of the values 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. For example, 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. Fortunately, 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. Use any one of these techniques to fix the value of the foreign subsidiary’s assets and liabilities to protect against potential exchange rate fluctuations.

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Translation Exposure

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Translation Exposure

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Transaction Exposure

See Also:
Translation Exposure
Currency Swap
Exchange Traded Funds
Hedge Funds
Fixed Income Securities

Transaction Exposure Definition

Transaction exposure, defined as a type of foreign exchange risk faced by companies that engage in international trade, exists in any worldwide market. It is the risk that exchange rate fluctuations will change the value of a contract before it is settled. This can also called transaction risk.

Transaction Exposure Meaning

The risk that foreign exchange rate changes will adversely affect a cross-currency transaction before it is settled, can occur in either developed or developing nations. A cross-currency transaction is one that involves multiple currencies. A business contract may extend over a period of months. Foreign exchange rates can fluctuate instantaneously. Once a cross-currency contract has been agreed upon, for a specific quantity of goods and a specific amount of money, subsequent fluctuations in exchange rates can change the value of that contract.

A company that has agreed to but not yet settled a cross-currency contract that has transaction exposure. The greater the time between the agreement and the settlement of the contract, the greater the risk associated with exchange rate fluctuations.


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Transaction Exposure Management

A company engaging in cross-currency transactions can protect against transaction exposure by hedging. By using currency swaps, by using currency futures, or by using a combination of these hedging techniques, the company can protect against the transaction risk by purchasing foreign currency. Use any one of these techniques to fix the value of the cross-currency contract in advance of its settlement.

Transaction Exposure Example

For example, a domestic company signs a contract with a foreign company. The contract states that the domestic company will ship 1,000 units of product to the foreign company and the foreign company will pay for the goods in 3 months with 100 units of foreign currency. Assume the current exchange rate is: 1 unit of domestic currency equals 1 unit of foreign currency. The money the foreign company will pay the domestic company is equal to 100 units of domestic currency.

The domestic company, the one that is going to receive payment in a foreign currency, now has transaction exposure. The value of the contract is exposed to the risk of exchange rate fluctuations.

The next day the exchange rate changes and then remains constant at the new exchange rate for 3 months. Now one unit of domestic currency is worth 2 units of foreign currency. The foreign currency has devalued against the domestic currency. Now the value of the 100 units of foreign currency that the foreign company will pay the domestic company has changed – the payment is now only worth 50 units of domestic currency.

The contract still stands at 100 units of foreign currency, because the contract specified payment in the foreign currency. However, the domestic firm suffered a 50% loss in value.

Manage Your Risk

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transaction exposure

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Currency Swap

See Also:
Currency Exchange Rates
Transaction Exposure
Exchange Traded Funds
Translation Exposure
Hedge Funds

Currency Swap Definition

Currency swaps are used to manage exchange rate risk. In a currency swap, two counterparties exchange the interest and principal payments on loans in different currencies. The counterparties agree to a set exchange rate, a set maturity, and a set schedule to pay interest and principal. By fixing the exchange rate for the transaction, both counterparties hedge the risk of unfavorable exchange rate fluctuations.

Currency Swap Example

For example, a British company may need to borrow US dollars. But the only rate it can get on a dollar loan is too high. At the same time, a US company needs to borrow pounds, but the only rate it can get on a loan in pounds is too high.

The British company, however, can borrow pounds at an attractive interest rate and the US company can borrow dollars at an attractive interest rate. So the two companies decide to enter into a currency swap agreement.

The US company borrows dollars cheaply and then lends them to the British company. Meanwhile, the British company borrows pounds cheaply and lends them to the US company. Through the swap agreement, both companies end up benefiting from the other company’s attractive home-currency borrowing rate. It is a win-win situation.

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Currency Exchange Rates

See Also:
Currency Swap
Transaction Exposure
Hot Money
Exchange Traded Funds
Required Rate of Return
Hedge Funds
Fiat Money

Currency Exchange Rates

An exchange rate gives the value of one currency in terms of another. An exchange rate can be computed for any two currencies. Exchange rates are typically quoted to at least four decimal places.

Foreign currencies are exchanged for investment and speculative purposes and for hedging risk. Foreign currencies are traded all over the world twenty-four hours a day via banks and brokerages. The foreign exchange market is the largest market in the world. Speculating in foreign exchange markets is considered very risky.

Fixed Exchange Rates vs. Floating Exchange Rates

An exchange rate can be fixed or floating. A fixed rate is determined and maintained by government central banks. A floating rate is determined by market forces.

A fixed rate, or peg, maintains a set exchange rate for one currency in terms of another. For example, assume the Chinese Yuan is pegged to the US Dollar. If the US Dollar declines in value, then the Chinese Yuan will also decline in value so that the exchange rate remains unchanged.

A floating rate allows the exchange rate between two currencies to fluctuate freely based on the supply and demand of each currency, as well as other relevant economic factors. For example, the exchange rate between the US Dollar and the Euro is a floating rate. Due to market forces, the exchange rate between these two currencies fluctuates continuously.

Currency Spot Prices

The spot exchange rate for two currencies is the rate of exchange for immediate (within two business days) delivery. For example, if a trader wants to exchange US Dollars for Euros today, he would do so at the spot rate.

Currency Forward Rate

The forward exchange rate for two currencies is the rate of exchange for future delivery. Forward rates are often quoted for 1-month, 3-month, and 6-month contracts. If a trader plans to exchange US Dollars for Euros three months from now, but wants to fix the price of the conversion today, he can do so by purchasing Euros at the 3-month forward rate. In three months the trader would receive the amount of Euros determined by the forward rate contract, regardless of the spot rate at that time.

Appreciation and Depreciation of Currency

Appreciation, or revaluation, refers to an increase in the spot rate value of one currency in relation to another.

Depreciation, or devaluation, refers to a decrease in the spot rate value of one currency in relation to another.

Direct Quote vs. Indirect Quote

A direct quote shows the home currency price of one unit of foreign currency. An indirect quote shows the foreign currency price of one unit of home currency. For example, consider these hypothetical direct and indirect quotes between the Euro and the US Dollar, using the US Dollar as the home currency:

Direct Quote:        $1.5501 = €1        (1/.6451)

Indirect Quote:      €.6451 = $1         (1/1.5501)

FOREX Rates (FX Rates)

Currency exchange rates are also called forex rates or fx rates.

Exchange Rate Converter

For foreign currency conversions, go to: www.oanda.com

Exchange Rates – Historical

For historic exchange rate data, go to: www.oanda.com

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