Foreign Exchange Exposure

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As mentioned previously, many organizations are at risk to the financial impact of the market due to changes in foreign exchange rates. In particular, there are three types of foreign exchange exposure:

Foreign exchange exposure is the risk of financial impact due to changes in foreign exchange rates.

6.3.1 Transaction exposure

Transaction exposure principally impacts a company's profit and loss and cash flow. It results from transacting business in a currency that is different from the currency of the company's home base. Companies face transaction exposure when they import or export goods and services denominated in foreign currencies, or when they borrow or invest in foreign currencies.

For example, when a small Irish vitamin company, a subsidiary of a large Dublin-based food conglomerate, imports cod liver oil from Sweden, it is invoiced in Swedish krona. Payment is due on delivery of the oil in three months, but in the next two weeks the food manufacturer has to fix the pricing levels and send a profit and loss forecast for the next six months to the treasurer of the parent company. The company has a transaction exposure because they have a risk that the Swedish krona will strengthen against the euro by the time the payment is due, making the cost of goods in euros greater than the company anticipated and possibly eroding their profit margins.

Of course, this exposure could be eliminated or mitigated through the use of foreign exchange products, such as a forward contract, which could lock in a specific exchange rate for settlement at the time the payment is due.

6.3.2 Translation exposure

Translation exposure principally impacts a company's balance sheet and results from the translation of foreign assets and liabilities into the company's home currency for accounting purposes. This occurs when the financial statements of a company's foreign subsidiaries are consolidated into the parent's statements and translated into the parent's reporting base currency. (Transaction and translation exposure occasionally overlap).

For example, a Swiss food company has an American subsidiary in the sweet business. The subsidiary company had an asset value of 52.5 million Swiss francs (or $35 million) at the beginning of the year, when the exchange rate was Sfr 1.50 per $1. There was no change in the asset value of the subsidiary during the year due to operational reasons. In that time, however, the Swiss franc strengthened to Sfr 1.43 per $1. The asset value of the sweet company on the Swiss company's balance sheet has dropped to Sfr 50 050 000 ($35 million at 1.43) a loss of Sfr 2 450 000 (52 500 000 minus 50 050 000), simply from the translation of the Swiss company's long-term investment in the American sweet company from dollars to Swiss francs.

Again, this exposure can be eliminated or mitigated through the use of foreign exchange products such as a forward contract or a currency option.

6.3.3 Economic exposure

Economic exposure relates to a company's exposure to foreign markets and suppliers. It can also be referred to as competitive, strategic or operational exposure and is more difficult to identify. In fact, identification of economic exposure involves in-depth forecasting to determine how sensitive the company's business is to changes in exchange rates. It recognizes that the value of a company is impacted by changes in the exchange rate on both its current and future products and markets. For instance, a company has foreign exchange exposure arising from payables and receivables that are not yet booked but will most probably occur. As these exposures cannot receive hedge accounting treatment, they are a problem for companies.

An example often cited in discussing economic exposure is that of a major American film manufacturer whose main competitor in most of its markets is a large Japanese Company. The American company has an active exchange rate risk-management programme, which recognizes that when the value of the yen rises against the dollar - say, from an exchange rate of 150 to 140 - the American film becomes more competitive with the Japanese film in Japanese markets, and the Japanese film becomes less competitive with the American film in American markets. When the yen weakens against the dollar - say, from an exchange rate of 140 to 150 - it has the opposite competitive impact.

Again, however, available products in the foreign exchange market can address any problems with economic exposure.

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