A firm dealing with foreign exchange may be exposed to foreign currency exposures. The exposure is the result of the possession of assets and liabilities and transactions denominated in foreign currency. When the exchange rate fluctuates, assets, liabilities, revenues, expenses that have been expressed in a foreign currency will result in either foreign exchange gain or loss. A firm dealing with the foreign exchange may be exposed to the following types of risks:
- Transaction Exposure: A firm may have some contractually fixed payments and receipts in foreign currency, such as import payables, export receivables, interest payable on foreign currency loans etc. All such items are to be settled in a foreign currency. Unexpected fluctuation in the exchange rate will have a favourable or adverse impact on its cash flows. Such exposures are termed as transactions exposures.
- Translation Exposure: Translation exposure is also called accounting exposure or balance sheet exposure. It is basically the exposure on the assets and liabilities shown in the balance sheet and which are not going to be liquidated in the near future. It refers to the probability of loss that the firm may have to face because of decrease in value of assets due to devaluation of a foreign currency despite the fact that there was no foreign exchange transaction during the year.
- Economic Exposure: Economic exposure measures the probability that fluctuations in the foreign exchange rate will affect the value of the firm. The intrinsic value of a firm is calculated by discounting the expected future cash flows with appropriate discounting rate. The risk involved in economic exposure requires measurement of the effect of fluctuations in the exchange rate on different future cash flows.