Type # 1.

Transaction Exposure:
A transaction exposure arises due to fluctuation in exchange rate between the
time at which the contract is concluded in foreign currency and the time at
which settlement is made. Transaction exposure is short term in nature,
usually for a period less than one year. The credit purchase and sales,
borrowing and lending denominated in foreign currencies, etc. are examples
of transactions exposure.

Parts of Transaction Exposure:

Transaction exposure basically covers the following:
a. Rate Risk:
This will occur

1. When there is mismatch of maturity period and borrowings amount;

2. In foreign exchange, it results in net exchange positions (long or short).

b. Credit Risk:
A situation when the borrower is not in a position to pay.

c. Liquidity Risk:
Same as in the case of credit risk. This exposure results from the possibility
of foreign exchange gains or losses when settlement takes place at a future
date of foreign currency dominated contracts. Such contracts might include
the import or export of goods on credit terms, borrowing or lending funds
denominated in a foreign currency, or a company having an unfulfilled
foreign exchange contract.

Transaction exposure is short-term form of economic exposure. Transactions

exposure could be of contractual exposure also. Transaction exposures
usually have short time horizon, and operating cash flows are affected.

Managing Transaction Exposure:y

ADVERTISEMENTS:Y

Management of transaction exposure requires deciding:

1. To what extent an exposure should be explicitly hedged,

2. Choosing the appropriate hedging vehicle, and

3. Evaluation of the alternate hedging strategies.

Illustration 1:
An Indian exporter has obtained an order for supplying automotive brakes at
the rate of $100 per piece. The exporter will have to import parts worth $50
per piece. In addition, variable costs of Rs.200 will be incurred per piece.
Explain the impact of Transaction exposure if the exchange rate which is
currently Rs.36/$ moves to Rs.40/$.

Solution:
Currently:
Revenues generated per piece = (100) (36) = Rs.3,600

Costs incurred per piece:

Impact of transaction Exposure:

Thus, contribution increases by Rs.200 (Rs.2,000-Rs.1,800) per piece on

account of transaction exposure.

Illustration 2:
An Indian exporter has an ongoing order from USA for 2,000 pieces per
month at a price of $100 per piece. To execute the order, the exporter has to
import Yen 6,000 worth of material per piece. Labour costs are Rs.350 per
piece while other variable overheads add up to Rs.700 per piece.

The exchange rates are currently Rs.35/$ and Yen 120/$. Assuming that the
order will be executed after 3 months and payment is obtained immediately
on shipment of goods, calculate the loss/gain due to transaction exposure if
the exchange rates change to Rs.36/$ and Yen 110/$.

Solution:
At the existing level of exchange rates:
Revenues = (2000) (100) (35) = Rs.70,00,000

Costs:

Hence, Profits = 70,00,000 – 56,00,000 = 14,00,000

After the exchange rates change:

Revenues = (2000) (100) (36) = Rs.72,00,000

Costs:
Material: (2,000) (6,000) (36/110) = Rs.39,27,272

Labour: (2,000) (350) = Rs.7,00,000

Overhead: (2,000) (700) = Rs.14,00,000

Total Costs Rs.60,27,272

Profits = 72,00,000 – 60,27,272 = Rs.11,72,728

So loss due to transaction exposure

= 14,00,000 – 11,72,728

= Rs.2,27,272
Type # 3. Translation Exposure:
The accounting recording of transactions give rise to the assets or liabilities,
hence whenever the parent firm tries to consolidate the position of
subsidiaries in their books, the Translation exposure comes into existence. It
is also known as an Accounting Exposure and also Balance Sheet Exposure.

Translation exposure measures impact of changes in foreign currency

exchange rate on the value of assets and liabilities. It indicates clearly that
pre-existing assets and liabilities values change on account of change in
foreign exchange rate. It is needed to be done with a specific intention to
reflect the correct and realizable position of the parent firm with respect to
financial strength because subsidiaries are part and parcel of the parent firm.

The assets and liabilities are consolidated in the parent firm’s balance sheet
through translation of each and every asset and liabilities of the firm by using
the exchange rate effective on the balance sheet date. Hence it can be
concluded that translation risk is the related measurement of variability in the
value of assets and liabilities in existence overseas.

According to the accounting rules, it is needed to consolidate worldwide

operations. Assets, Liabilities, revenues, and expenses are to be restated in
terms of the home currency of the parent company in the consolidated results
being prepared.

Being all this transactions exposed to foreign currency exchange risk, the
translation methods don’t help in deriving exact foreign exchange gains and
losses. The gains and losses need to be recognized and the main methods are
current or non- current, monetary or non-monetary, temporal and current rate.
The key difference between the transaction exposure and translation exposure
is that the transaction exposure impacts the cash flow of the firm whereas
translation has no effect on direct cash flows.

When the firm’s foreign balances in terms of assets and liabilities are
expressed in terms of the domestic currency the translation exposure occurs.
This translation exposure arises due to changes in exchange rates and thus
alters the values of assets, liabilities, expenses and profits or losses of the
foreign subsidiaries.

Financial Decisions Involved:

Two related decision areas involved in translation exposure management are:
i. Managing balance sheet items to minimize the net exposure,

ii. Deciding how to hedge against exposure.

Financial managers should attempt to keep a rough balance between exposed

assets and liabilities, by offsetting changes in values. If the value of the
currency declines relative to the currency of the home country, then the
translated value of assets and liabilities will be lower. An asset denominated
in terms of foreign currency will lose value if that foreign currency declines
in value.
The calculation of translation gains and losses is a paper exercise. These
gains and losses do not involve any actual cash flow. Some firm, however, is
concerned about this risk because it affects their cost of capital, earnings per
share, and the stock price, besides the ability to raise capital in the market.

Illustration 5:
Assume that Mani (India) Ltd., has a wholly owned subsidiary, Priety Inc. in
USA. The exposed assets of the subsidiary are $200 million and its exposed
liabilities are $100 million. The exchange rate changes from $0,020 per rupee
to $0,021 per rupee.

The potential foreign exchange gain or loss to the company will be calculated
as follows:
In this case, the net exposure is:
if the post-devaluation rate is $0,019, then

Post Devaluation Value, ($100 million ÷ 0.019) = Rs.5,263 million

In this case,

Potential Exchange Gain – Rs.263 million

Illustration 6:
Consider an Indian firm having a UK subsidiary with exposed assets equal to
£100 million and exposed liabilities equal to £50. How the Indian firm can
create a balance sheet hedge?

Solution:
UK subsidiary with exposed assets equal to £100 million and exposed
liabilities equal to £50 is equivalent to Indian firm having a translation
exposure of £50 million. To create a balance sheet hedge, the Indian firm can
borrow £50 million. Thus, net translation exposure will be zero and the
accounting books will not be affected by changes in the £/Rs. exchange rate.

Type # 4. Economic Exposure:

The economic exposure refers to the change in value of firm on account of
change in foreign exchange rate. The intrinsic value of the firm is equal to the
sum of the present values of future cash flows discounted at an appropriate
rate of return.

The rate of return is worked out on the basis of the risk element in the total
economic exposure including the operating exposure of the firm. The rate of
return is worked out taking into effect the changes in the exchange rates and
its effect on the future cash flows of the firm, which can be termed as
operating exposure also.

The firm’s economic exposure is translation exposure plus relevant

transaction exposure at the time of the assessment of the total economic
exposure of the firm. The translation exposure doesn’t affect the cash flows
of the firm, but may indirectly affect future cash flows.

The two cash flow exposures – operating exposures and transaction exposure
– combine to equal a firm’s economic exposure. Economic exposure is
measured by taking in to consideration the expected future cash flow duly
adjusted by exchange rate, and then through the application of rate of return,
the present value is worked out.

The favourable factors in a country like stability, low rates of taxation, easy
availability of funds, and positive balance of payment may change over time
because of variations in the economic condition of a country. The local
currency may also be devalued or depreciated as a result of changes in the
economic forces.

As a result of changes in exchange rates, various economic barometers of a

country change. The inflationary forces, demand and supply of funds, and
various kinds of various price controls, economical controls laid by the
legislators, are also affected as a result of change in exchange rates.

The economic exposure of a firm includes all the facets of a firm’s operations
including the effects of changes in exchange rates on the customers,
suppliers, competitors; and all other factors of environment in which firm is
operating. The economic exposure of a firm is difficult to measure and to
provide with any figure of economic exposure can be termed as an
ambiguous figure.

Economic loss is broader in nature than the translation and the transaction
exposures. In fact, the transaction and translation exposure are termed as one-
time events, whereas economic exposure is a continuous one. Hence, it can
be said that if transaction or translation exposure exists, economic exposure
also exists, but vis-a-vis doesn’t hold true.

Unexpected currency fluctuations can affect the future cash flows and the
riskiness of the cash flows; and impact the value of the company. If the
finance manager considers foreign exchange exposures to be material, then
there are number of policies that he might choose to adopt to try to protect his
company against such exposures. The difference occurred in the present
value of future cash flow on account of expected or real change in exchange
rate over the period, is normally termed as Economic value of the firm.

If a firm manufactures specially for exports and finances itself on the local
market, an appreciation of local currency will have a negative impact on the
net cash flows, as its sales are likely to be affected to a higher degree than its
expenses. If, on the other hand, the local currency depreciates, cash flows are
affected exactly in the opposite way.

Exports should increase, as manufacture products are more competitive. But

if the firm imports a significant part of its inputs, its expenses will increase
and thus its cost of production will go up. If the company has borrowed
abroad, its financial charges will also increase.
A depreciation of local currency, in general, results into an increase of
operating revenues as well as expenses. Here again, there is a need to
examine whether the impact of depreciation is greater on revenues or
expenses. The economic exposure of multinational is difficult to evaluate by
firm, hence he try to forecast the future rates and its impact on firm’s
performance.

Illustration 7:
Assume that the Danish subsidiary of an Indian company is likely to earn 100
million Kroner each year. The annual depreciation charges are estimated at
10 million Kroner. The exchange rate between the countries is likely to
change from Rs.9.60 per Danish Kroner to Rs.8.00 per Kroner in the next
year.

Solution:
The change in the exchange rate will have the following effect on the cash
flows of the parent company:

Thus, the Indian company loses Rs.1 76 million in cash flows over the next
one year. If the anticipated business activity would be same for the next five
years, the net cash flows would decrease by Rs.880 million. (Rs.176 million
× 5 years)
The total overall impact of the economic exposure on the value of the
company depends on the classification or distribution of sales in the various
export markets and domestic markets, the elasticity of the demand of the
product in each market, the number of products in which firm deals in, and
the cost structure of the affiliates.
Differences among Economic, Transaction and Translation Exposures:
The major differences among these exposures are given below in Table 8.1:

A firm is continuously exposed to the foreign exchange rate changes at every

stage in the processes of capital budgeting, developing new products to
entering into contracts, to sell products in foreign market.

The transaction exposure has an impact on the reported net income because it
is affected by exchange rate related losses and gains. The exchange rate
losses and gains as a result of translation exposure only affects the firm’s
accounting record and are not realized, hence doesn’t affect the taxable
income of the firm.

If the financial market is not efficient across the globe, then the firm has to
resort to the hedging tools to achieve the goal of weal maximization. While,
if financial market is efficient not need to use the hedging tools.

Illustration 8:
On 1st February, a business entity in Mumbai purchases materials from Euro
land. The invoice amount of 5, 00,000 Euro is payable at the end of April.
The Spot rote on 1st February was Rs.49.50 – 50.00 per Euro. The entity
incurs a conversion expenditure of Rs.50 lakh. Finished goods were sold to a
company in USA on 15th March.
Invoice value of FC was US $ 12,50,000/-. Terms of sale included payment
at the end of April. Spot rate on 15th March was Rs.45-46 per $. Other
selling expenses amounted to Rs.10 lacs. At the end of April, the spot rates
stood at, (a) Rupee – Euro: Rs.51.00-52.00 and (b) Rupee – $: Rs.44-45.

Required:
i. Compute and show the actual cash profit

ii. Comment on exchange rate movements

iii. Name the nature of risk

Solution:
a. Computation of Actual Profit:
WN 1: Accounting on transaction date(s):
WN 2: Impact on profits due to Exchange rate movement:

Note 1:
For purchase of materials, the entity has to make payment and hence the
Bank’s selling rate will apply. The rate had moved adversely from Rs.50 to
Rs.52.

Note 2:
On receipt of sale proceeds in USD, the entity will sell the foreign currency
to the Bank. Hence the Bank’s buying rate will apply. The rate that stood at
Rs.45 had moved adversely to Rs.44/-.

b. Comments on Exchange Rate Movement:

i. Short-term movements in exchange rates are difficult to predict. The
adverse movements have taken place between transaction date and settlement
date.

ii. It is possible for one currency (Rupee) to weaken against a currency

(Euro), and yet, strengthen against a third currency (Dollar). Also, the extent
of weakening or strengthening need not be uniform, as is emerging in this
case. (2/50 is not the same as 1/45)

iii. This risk is referred to as transaction risk.