The following points highlight the three main types of foreign exchange exposure. The types are: 1. Transaction Exposure 2. Translation Exposure 3. Operating Exposure.
Type # 1. Transaction Exposure:
It refers to the sensitivity of the domestic currency value of foreign currency-denominated transactions arising from credit purchases and credit sales. Whenever a company makes credit purchases or credit sales invoiced in a foreign currency, it would need to make payment (for credit purchases) and receive cash (for credit sales) in foreign currency. The future cash outflows and inflows in domestic currency will depend on the exchange rate on the future date on which payment and receipt occurs.
If the domestic currency depreciates by that future date, its outflow is higher than expected, and inflow is also higher than expected. If the domestic currency strengthens, the domestic currency outflow (for credit purchases) is lower than expected, and the domestic currency inflow (for credit sales) is lower than expected. Therefore, when the domestic currency depreciates, exporters are benefited but importers are adversely affected. When the domestic currency appreciates, the reverse is true-importers are benefited but exporters are adversely affected.
Type # 2. Translation Exposure:
It is also known as accounting exposure. It is the sensitivity to changes in exchange rates of the domestic currency value of the financial statements of overseas affiliates (when converted into the parent company’s home currency). When the parent company’s home currency weakens against the currency of the overseas affiliate, then the overseas affiliate’s profit, assets and liabilities will be higher when expressed in the home country currency. Translation exposure is favourable.
If, on the other hand, the parent company’s home currency strengthens against the currency of country in which the overseas affiliate is located, translation exposure is unfavourable. The overseas affiliate’s profit, assets and liabilities shrink when converted into the parent company’s home currency.
Type # 3. Operating Exposure:
It is the sensitivity to changes in exchange rates of the domestic currency value of the future stream of foreign currency revenues and costs. Operating risk arises from future courses of action that will generate foreign currency revenues and costs. Such courses of action have strategic implications and affect the company’s future profitability. Accepting an overseas capital budgeting proposal is one example. It will result in cash inflows and outflows stretching over a number of years.
Any changes in the expected exchange rate over these years will alter the company’s future profitability, which in turn affects the current value of the company (since the currency value is the sum of the present value of future cash flows). Operating exposure affects those companies that undertake overseas projects either on a turnkey basis, or on an ownership basis.
There are regional differences in the importance accorded to transaction, translation and operating exposure. Translation exposure is given greater importance by MNCs in the UK and the Asia-Pacific region, compared to US MNCs. Transaction exposure is given the maximum importance by American MNCs.