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Types of Foreign Exchange Exposures
With globalization and cross country operations, the need to manage foreign exchange has become a crucial part of any business. An exporter engaged in export of goods receives payment in foreign currency. Similarly an importer may require foreign currency to make payments to its suppliers in different countries. Globalization has increased business opportunities, but at the same time exposes any business to a number of risks. One such risk arises from fluctuations in foreign exchange rates.
Foreign exchange risk arises from the possibility of deviation in the value of domestic currency. Such variation results from unexpected changes in foreign exchange rate and can have a positive or negative effect on the value of any asset, liability or income of any company engaged foreign currency transactions. For instance, an Indian importer imports goods from USA. Payment is expected to be made within 30 days from the date of receipt of shipment. On the day when importer entered into purchase transaction, rate per dollar was Rs. 45/-. However on the date of receipt of shipment, rate per dollar was Rs. 47.50/-. As a result of this increase in rate, importer will have Rs. 2.50/- extra for each dollar. If goods were worth 50,000 USD, net loss to the importer will be equal to Rs. 1, 25,000/- . Now let us take another scenario where rate per dollar decreases to Rs. 43.50/-. In this case importer will save Rs. 75,000/-. This is a simple example of how exchange rate fluctuations can impact profitability of any business.
Let Us Focus On The Three Types Of Foreign Exchange Exposures Which Are Described Below:
Transaction exposure arises from due to fluctuations in exchange rate between the time the transaction took place and the time by when it is finally settled. Let us understand this with the help of an example. An Indian exporter has made a credit sale to a company in USA. Total value of goods was 70,000 USD. Exporter reports the receivables in its books of accounts in USD only. Payment for this shipment is expected within 30 days from the date of shipment of goods. At the time of shipment of goods, rate per dollar was Rs. 45/- and when payment was received by the exporter rate per dollar was Rs. 46.5/-. Here exporter benefited to the extent of Rs. 1.50/- per dollar. Had there been a decline in the rate, exporter would have suffered a loss. Here the settlement date would be the date when money was received by the exporter. Hence transaction exposure arises mainly on account of routine operations of any company. Here it is interesting to note that had payment been accepted in Indian rupees, there would have been no effect on the actual earnings of the exporter. Any transaction which involves dealing in foreign currency can expose a business to transaction exposure.
Irrespective of the size, country or nature, every business is required to maintain proper books of accounts. At the end of financial year, businesses are required to report all of their assets, liabilities and incomes in their domestic currency. Further these figures are required to be reported at the values which they will derive if liquidated as on the date of finalization, that is, at current realizable values. If a company has any foreign currency denominated asset, liability or any income which is to be received in foreign currency, it will require a translation into domestic currency to report accurate figures.
In comparison to transaction exposure where loss or gain actually takes place, translation exposure does not result in actual gains or losses, since conversion is done only for the purpose of reporting correct figures whereas in reality there is no liquidation of relevant asset, liability or income. For instance, a company had a bank balance of 25,000 USD at the beginning of the financial year while at the end its bank balance increased to 26,000 USD. At the start of the financial year, rate per dollar was Rs. 48/- while at the end it reduced to Rs. 46/-. To report, company will have to convert its bank balance at the end of the year at the current rate of Rs. 46, thereby resulting in a bank balance of Rs. 11, 96, 000/-. At the beginning of the year, this value would have been Rs. 12, 00,000/- (25000*48). Hence it can be seen that even though the company’s bank balance has increase by 1000 USD, its actual value in Indian rupees at the end of financial year has come down by Rs. 4,000/-. This type of exposure also holds relevance in case a company has a foreign subsidiary and is engaged in transaction in domestic currency of that country.
Any change in the future cash flows or profits of a firm as a result of any unexpected change in the exchange rate is known as operating exposure. It is also called economic exposure or competitive exposure. Here a business tries to estimate the volume of loss or gain that may arise due to changes in the value of future operating flows as a result of changes in exchange rate. Company’s operations are studied over a period of time which can be few months or even a year.
It is more of estimation and hence a little difficult to measure as accurately as other two types of exposures. Unlike transaction and translation exposure, operating exposure cannot be related to specific cash flows, assets or liabilities. Operating exposure may not result in any direct impact on the financial position of any company, but it can affect the operating competitiveness. Operating exposure is important from the long run perspective of an organization’s business operations. Even a difference in the level of inflation between two countries can impact the competitive position of the company through its impact on future cash flows denominated in foreign exchange and over all profitability of the company.
Various mechanisms are available to deal with foreign exchange risks. Proper guidelines and policies as to how much exposure a firm can withstand should be prepared and planned for in advance by the management.