There are two type of exchange rate risks. There is translation risk and economic risk. These two types of risks are defined in this article.
Any company involved in importing and exporting or providing international services must be prepared to accept foreign currencies. Transaction risk is associated with fluctuations in the exchange rate value of one currency in comparison to others. For example, an American company sells software to a French manufacturer for €15,000 and offers payment terms of 90 days. The sales contract specified that payment must be made in euros. Currently, the spot rate of
Foreign exchange market price at which a currency will be delivered on the spot date. Spot rate is the starting point for all foreign exchange transactions.
At the current spot rate of €1/$1.11, the American software producer expects to receive €15,000. However, if the French company uses the full 90-days to pay and in that time, the exchange rate changes to €1/$1.21, the American company will only receive €12,396 when the currency is traded for dollars. This represents a 17.36% reduction in what was expected. Therefore, companies must be prepared to deal with currency appreciation and depreciation when working completing overseas transactions.
When consolidating accounts, the financial translation of values of overseas assets from the foreign currency into the domestic currency must be performed. The profit and loss account of the foreign currency account need to be translated and consolidated too. Therefore, translation risk is the risk associated with an overseas asset or liability either increasing in value or decreasing in value due to changes in exchange rates. While translation gains and losses only appear on paper and aren’t actual cash flows, they can influence the choices of investors.
An example of translation risk is a U.S. company that purchases a manufacturing plant in France. The manufacturing plant is financed in U.S. dollars. The cost of the plant is €10,000,000, which at the current exchange rate of €1/$1.11 is $11,100,000. 12 months later, these manufacturing plant has retained 100% of its value, but the exchange rate is now €1/$1.21. While the amount financed to purchase the manufacturing plant has remained consistent, the value reflected for consolidation purposes will be $12,100,000.