Types of Foreign Exchange (Currency) Exposure

Foreign exchange exposure is classified into three types viz. Transaction, Translation, and Economic Exposure. Transaction
exposure deals with actual foreign currency transactions. Translation exposure deals with the accounting representation
and economic exposure deals with little macro-level exposure which may be true for the whole industry rather than just
the firm under concern. Let us see in detail the Types of Foreign Exchange Exposure.

Foreign exchange exposure is said to exist for a business or a firm when the value of its future cash flows is dependent on
the value of foreign currency/currencies. If a British firm sells products to a US Firm, the cash inflow of the British firm is
exposed to foreign exchange. And in the case of the US-based firm cash outflow is exposed to foreign exchange. Why we
are so skeptical about this exposure? Simple! It is because the exchange rates tend to change or fluctuate.

Table of Contents
1. Transaction Exposure:
2. Translation Exposure:
3. Economic Exposure:

In the above situation, we saw how a firm directly involved in foreign currency dealing is exposed to the risk of foreign
exchange. It may be surprising to know that a firm with no such direct connection may also be found exposed to foreign
currency risk. Just to share an example, if a company producing small electronics products in Sri Lanka is competing
against the products imported from China.

Now if the price of the Chinese Yuan per Sri Lankan Rupee is decreased. There will be a decrease in cost advantage to the
importers over that Sri Lankan company. It is evident from the example that the firm that has no direct access to forex
can also be impacted.

Commonly, the exposure is classified into three types of foreign currency exposure:

Transaction Exposure:
The simplest kind of foreign currency exposure that anybody can easily think of is transaction exposure. As the name itself
suggests, this exposure pertains to the exposure due to an actual transaction taking place in business involving foreign
currency. In a business, all monetary transactions are meant for profits as its end result. There are all the chances of that
final objective getting hampered if it is a foreign currency transaction. And the currency market moves towards an
unfavorable direction.

If you have bought goods from a foreign country and payables are in foreign currency to be paid after 3 months. Then, you
may end up paying much higher on the due date as currency value may increase. This will increase your purchase price.
And therefore the overall costing of the product compels the profit percentage to go down or even convert to loss.

Transaction exposure normally occurs due to foreign currency debtors of sale, payment for imported goods or services,
receipt/payment of dividend, or payment towards the EMIs of debts, etc.

Translation Exposure:

This exposure is also well known as accounting exposure. It is because the exposure is due to the translation of books of
accounts into the home currency. Translation activity is carried out on account of reporting the books to
the shareholders or legal bodies. It makes sense also as the translated financial statements show the position of the
company as on a date in its home currency.

Gains or losses arising out of translation exposure do not have more meaning over and above the reporting requirements.
Such exposure can even get reversed in the next year’s translation if the currency market moves in a favorable direction.
This kind of exposure does not require too much management attention.

Economic Exposure:

The impact and importance of this type of exposure are much higher compared to the other two. Economic exposure
directly impacts the value of a firm. That means the value of the firm is influenced by the foreign exchange.

The value of a firm is the function of operating cash flows and the assets it possesses. The economic exposure can have
bearings on assets as well as operating cash flows. Identification and measuring this exposure is a difficult task. Although,
the asset exposure is still measurable and visible in books the operating exposure has links to various factors such as
competitiveness, entry barriers, etc. Which are quite subjective and the interpretation of different experts may be
different.

These three types of foreign currency exposures are very important to understand for an international finance manager.
Analyzing the exposure to foreign exchange helps have the right view of the firm’s business and therefore make informed
decisions.

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