Introduction to Financial Management

The exchange rate fluctuations increase the riskiness of the investment (when the

contract is written in terms of the foreign currency or denominated in the foreign

currency) and incur cash losses.

o Types of Foreign Exchange Exposure

MNCs financial managers are faced with the dilemma of three different types of foreign

exchange risk. They are:

Translation exposure often called accounting exposure measures. The impact of an

exchange rate change on the firm’s financial statements

Transaction exposure measures potential gains or losses on the future settlement of

outstanding obligations that are denominated in a foreign currency. Operating

exposure, often called economic exposure, is the potential for the change in the present

value of future cash flow due to an unexpected change in the exchange rate.

Foreign exchange risk can be centralized or lodged by a change in the asset and

liability position in the foreign currency

Foreign exchange gains or losses can result from both transaction and translation

exposure. Transaction gain and losses result from either un-hedging or partially hedged

foreign currency exposure.

This exposure is created by terms such as Accounts Receivables or Accounts Payables

resulting from sales and purchases denominated in foreign currencies. Foreign-currency

exchange gains and losses occurs when the rates change, and the value of the foreign-

currency assets and liabilities will expand and contract.

Translation gains or losses result from either un-hedged or partially hedged exposure

associated with foreign subsidiaries. Translation exposure depends on the mix of assets

and liabilities of the foreign subsidiary. Operating characters of foreign subsidiaries and

foreign economy are also determining factors of both exposure and translation methods.