Foreign exchange exposure is classified into three types viz. Transaction, Translation and Economic Exposure. Transaction exposure deals with actual foreign currency transaction. Translation exposure deals with the accounting representation and economic exposure deals with little macro level exposure which may be true for the whole industry rather than just the firm under concern.
Foreign exchange exposure is said to exist for a business or a firm when the value of its future cash flows is dependent on the value of foreign currency / currencies. If a British firm sells products to a US Firm, cash inflow of British firm is exposed to foreign exchange and in case of the US based firm cash outflow is exposed to foreign exchange. Why we are so skeptical about this exposure? Simple! It is because the exchange rates tend to change or fluctuate.
Commonly, the exposure is classified into three types of foreign currency exposure:
Transaction Exposure: The simplest kind of foreign currency exposure which anybody can easily think of is the transaction exposure. As the name itself suggests, this exposure pertains to the exposure due to an actual transaction taking place in business involving foreign currency. In a business, all monetary transactions are meant for profits as its end result. There are all the chances of that final objective getting hampered if it is a foreign currency transaction and the currency market moves towards the unfavorable direction.
If you have bought goods from foreign country and payables are in foreign currency to be paid after 3 months, you may end up paying much higher on the due date as currency value may increase. This will increase your purchase price and therefore the overall costing of the product compelling the profit percentage to go down or even convert to loss.
Transaction exposure normally occurs due to foreign currency debtors of sale, payment for imported goods or services, receipt / payment of dividend, or payment towards the EMIs of debts etc.
Translation Exposure: This exposure is also well known as accounting exposure. It is because the exposure is due to translation of books of accounts into the home currency. Translation activity is carried out on account of reporting the books to the shareholders or legal bodies. It makes sense also as the translated financial statements show the position of the company as on a date in its home currency.
Gains or losses arising out of translation exposure do not have more meaning over and above the reporting requirements.
Economic Exposure: The impact and importance of this type of exposure is much higher compared to the other two. Economic exposure directly impacts the value of a firm. That means, the value of the firm is influenced by the foreign exchange.
The value of a firm is the function of operating cash flows and the assets it possess. The economic exposure can have bearings on assets as well as operating cash flows. Identification and measuring of this exposure is a difficult task. Although, the asset exposure is still measureable and visible in books but the operating exposure has links to various factors such as competitiveness, entry barriers, etc which are quite subjective and interpretation of different experts may be different.
These three types of foreign currency exposures are very important to understand for an international finance manager. Analyzing the exposure to foreign exchange helps have the right view of the firm’s business and therefore take informed decisions.