Written by in P2P on August 23, 2021
Foreign exchange exposure is something that anyone who transacts or does business in more than one currency should be aware of. In its essence, forex exposure refers to the risk that a company takes on when making transactions in foreign currencies. If a business is looking to transact across multiple currencies, it’s important that they first identify their exposure to risk in order to put a calculated risk management strategy in place.
There are three main types of forex exposure: transaction exposure, translation exposure, and economic exposure.
Transaction exposure is considered a “short-run” type of forex exposure. It refers to the risk that is taken on when carrying out a transaction involving foreign currency. If the currencies you are transacting in rise or fall in an unfavourable direction, it can negatively impact you financially and this is the nature of transactional risk, namely that you are transacting in different currencies and exposing yourself to potential loss in the face of fluctuation.
As most business transactions have the ultimate goal of turning a profit, this type of exposure can impact your bottom line if you are dealing with large-volume transactions and particularly volatile currencies.
Translation exposure, on the other hand, comes about when translating books or records of accounts into your local currency. Basically, this type of exposure is relevant in the case that you are pulling reports or showing financial statements to governing bodies or shareholders, for example. Just as you would translate something into another language, you may need to translate your accounts or assets into your home currency for reporting or record-keeping purposes.
If the foreign currency has moved in an unfavourable direction at the time of translation it could impact your numbers and potentially the opinions or contingencies associated with those whom you are reporting to.
While this type of exposure isn’t necessarily risky, it’s worth being aware of as it is something that can impact your outward-facing value. Luckily, this is typically temporary as things can sway back in the other direction.
Finally, economic exposure. This exposure type is the most significant and the most impactful. It is considered a “long-run” exposure type on account of its long-winded and high-level ramifications. Economic exposure is the degree to which a business's overall value is directly impacted by foreign exchange.
If your business is heavily exposed to risk in this way, it means that unexpected currency fluctuations can affect your future cash flows, investments, earnings, and overall market value.
The other two exposure types measure your risk in specific circumstances whereas economic exposure measures your overall risk as a result of foreign exchange fluctuations.
Economic exposure can be mitigated through both operational strategies or risk management strategies.
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