Foreign Exchange Risk

Foreign exchange risk arises through transaction, translation, and economic exposures. It may also arise from commodity-based transactions where commodity prices are determined and traded in another currency.

Transaction Exposure

Transaction risk impacts an organization’s profitability through the income statement. It arises from the ordinary transactions of an organization, including purchases from suppliers and vendors, contractual payments in other currencies, royalties or license fees, and sales to customers in currencies other than the domestic one. Organizations that buy or sell products and services denominated in a foreign currency typically have transaction exposure.

Management of transaction risk can be an important determinant of competitiveness in a global economy. There are few corporations whose business is not affected, either directly or indirectly, by transaction risk.

Translation Exposure

Translation risk traditionally referred to fluctuations that result from the accounting translation of financial statements, particularly assets and liabilities on the balance sheet. Translation exposure results wherever assets, liabilities, or profits are translated from the operating currency into a reporting currency—for example, the reporting currency of the parent company.

From another perspective, translation exposure affects an organization by affecting the value of foreign currency balance sheet items such as accounts payable and receivable, foreign currency cash and deposits, and foreign currency debt. Longer-term assets and liabilities, such as those associated with foreign operations, are likely to be particularly impacted. Foreign currency debt can also be considered a source of translation exposure. If an organization borrows in a foreign currency but has no offsetting currency assets or cash flows, increases in the value of the foreign currency vis-a-vis the domestic currency mean an increase in the translated market value of the foreign currency liability.

Foreign Exchange Exposure from Commodity Prices

Since many commodities are priced and traded internationally in U.S. dollars, exposure to commodities prices may indirectly result in foreign exchange exposure for non-U.S. organizations. Even when purchases or sales are made in the domestic currency, exchange rates may be embedded in, and a component of, the commodity price.

In most cases, suppliers of commodities, like any other business, are forced to pass along changes in the exchange rate to their customers or suffer losses themselves. IN THE REAL WORLD By splitting the risk into currency and commodity components, an organization can assess both risks independently, determine an appropriate strategy for dealing with price and rate uncertainties, and obtain the most efficient pricing.

Protection through fixed rate contracts that provide exchange rate protection is beneficial if the exchange rate moves adversely. However, if the exchange rate moves favorably, the buyer might be better off without a fixed exchange rate. Without the benefit of hindsight, the hedger should understand both the exposure and the market to hedge when exposure involves combined commodity and currency rates.

Strategic Exposure

The location and activities of major competitors may be an important determinant of foreign exchange exposure. Strategic or economic exposure affects an organization’s competitive position as a result of changes in exchange rates. Economic exposures, such as declining sales from international customers, do not show up on the balance sheet, though their impact appears in income statements.

For example, a firm whose domestic currency has appreciated dramatically may find its products are too expensive in international markets despite its efforts to reduce costs of production and minimize prices.

IN THE REAL WORLD The prices of goods exported by the firm’s competitors, who are coincidentally located in a weak-currency environment, become cheaper by comparison without any action on their part.