Tag Archives | foreign exchange

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.

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Financial Instruments

See Also:
What is a Bond
Required Rate of Return
Return on Asset
Commercial Paper
Hedging Risk
Histogram

Financial Instruments and Securities

Financial instruments are contracts that represent value. They come in many varieties. In fact, financial managers and bankers have a lot of leeway in creating and issuing financial instruments. The Securities and Exchange Commission (SEC) regulates publicly traded financial instruments; however, the SEC less stringently regulates private placement instruments. Most financial instruments fall into one or more of the following five categories: money market instruments, debt securities, equity securities, derivative instruments, and foreign exchange instruments.


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Money Market Instruments

Money market instruments are highly marketable short-term debt securities. Furthermore, money market instruments are generally low-risk investments. Because of this, they offer yields that are lower than riskier stocks and financial instruments.

Often, investors trade money market instruments in large denominations among institutional investors. However, some money market instruments are available to individual investors via money market funds, or mutual funds that pool money market instruments.

Money market instruments include treasury bills, repurchase agreements, certificates of deposit, commercial paper, bankers’ acceptances, Eurodollars, and federal funds.

Debt Securities

Debt securities are longer-term debt instruments. With debt instruments, the issuer is essentially borrowing money from the investor. The investor plays the role of a lender lending money to the issuing entity. Longer-term debt securities often yield higher returns than money market instruments. Debt instruments also represent a claim on the assets of the issuing entity.

Debt securities are often called fixed-income securities. This is because the investor or lender often predetermines the terms of the debt instrument. For example, a debt instrument will be issued with a certain maturity, a certain principal amount, and a set coupon rate. However, while debt securities are often called fixed-income securities, this does not mean they yield a fixed stream of payments – debt securities’ returns can fluctuate and vary.

Examples of debt securities include: treasury notes, treasury bonds, inflation-protected treasury bonds, federal agency debt, international bonds, municipal bonds, corporate bonds, junk bonds, mortgages, mortgage-backed securities, and other types of debt.

Equity Securities

Equity securities represent shares of ownership in a company. In addition, equity securities often come with voting rights. They represent the shareholders’ interest in the issuing company and a residual claim on the company’s assets. This means if the issuing company goes bankrupt and has its assets liquidated, then the equity holders only get their money back after all other relevant claimants have been paid what they are owed.

Equity securities may be traded publicly on stock exchanges, they may be traded in over-the-counter (OTC) transactions, or they may be exchanged and held privately. Types of equity securities include common stock, preferred stock, and American Depository Receipts (ADR).

Financial Derivative Instruments

A financial derivative instrument is a contract that derives its value from an underlying asset or factor. In short, the value of a derivative depends on the value of something else. When the value of the underlying factor changes, the value of the derivative instrument also changes. Derivatives are often used for speculation, for leveraging a position, or for hedging risk.

Common derivatives include futures, forwards, options, and swaps. Common underlying assets or factors include stocks, bonds, currency exchange rates, commodity prices, market indices, and interest rates. However, derivatives can derive their value from almost anything, including weather data and political election outcomes.

Foreign Exchange Instruments

Another category of financial instruments is foreign exchange instruments. These are contracts involving different currencies. There are many currencies in the world, and there are several different instruments commonly used to trade in currencies.

The value of one currency relative to another depends on the exchange rate between the two currencies. Consider exchange rates either fixed or floating. Types of foreign exchange instruments include spot contracts, forward contracts, options, futures, and swaps.

Exchange foreign currencies for investment and speculative purposes and for hedging risk. You can trade foreign currencies all over the world twenty-four hours a day via banks and brokerages. The foreign exchange market is the largest market in the world. Consider speculating in foreign exchange markets very risky.

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financial instruments, money market instruments

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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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