INTERNATIONAL FINANCE

ASSIGNMENT-1: DIFFERENT TYPES OF FOREIGN

EXCHANGE RISK
The exchange rates of foreign currencies keep on changing which leads to vulnerability of a
firms assets, liabilities and cash flows due to such changes. This is known as foreign
exchange risk. There are two types of risks- translation risk and economic risk.

1. TRANSLATION RISK:It is also called accounting risk. It represents the extent to which a firm bears risk on its
financial reporting due to exchange rate movements. It results from the need of a global firm
to consolidate its financial statements to include results from foreign operations.
Consolidation involves translating subsidiary financial statements from local currencies (in
the foreign markets where the firm is located) to the home currency of the firm (i.e., the
parent) which can result in either translation gains or translation losses. There is no cash
movement involved as the subsidiary is not to be liquidated. So, this risk doesnot affect the
cash flows of the business.
For example- value of land and building of a US firms subsidiary in India is Rs.50,00,000.
At spot rate of Rs.60 by the end of the financial year it values $83,333. However, during the
year, there has been a depreciation of Indian Rupees to Rs. 65. If the parent company requires
to translate the subsidiarys balance sheet from rupee to dollar at the current exchange rate, it
suffered a translation loss of $6,410 as the translated value has declined to $76,923. But it
would have made a translation gain on the subsidiarys liabilities like debt in rupees.

ECONOMIC RISK: Risk associated with sensitivity of cash flows of a firm due to
unanticipated changes in the exchange rates of foreign currencies. They are divided into two
types which are discussed below.

2. TRANSACTION RISK:When a firm bears the risk of favourable or adverse impact- on its present cash flows due to
unanticipated change in the exchange rate is called transaction risk. It happens whenever a
firm has contractual cash flows whose values are subject to unanticipated changes in
exchange rates due to a contract being denominated in a foreign currency. To realize the
domestic value of its foreign-denominated cash flows, the firm must exchange foreign
currency for domestic currency. As firms negotiate contracts with set prices and delivery
dates in the face of a volatile foreign exchange market, with exchange rates constantly
fluctuating, the firms face a risk of changes in the exchange rate between the foreign and
domestic currency. It refers to the risk associated with the change in the exchange rate
between the time an enterprise initiates a transaction and settles it. Thus, it is also referred to
as contractual exposure. This risk results from foreign currency transactions already entered
into by a firm. These risks have a short time horizon.
Transactions involving cross-border transactions like export and import of goods & services,
intra-firm transfer of funds, payment of interest, royalty or dividend, repayment of loan can
result in exposure of corporations to such risks.

For example- an Indian company borrowed a loan of $5million at interest rate 4% p.a. The
principal amount realised was Rs.30crores (1 US $ = Rs.60). The interest amount payable
after 1 year at 4% is Rs. 1.2crores. When realised in US currency it amounts to $1, 96, 721 (1
US $ = Rs. 61) whereas the actual interest to be paid is $200,000. So the company makes an
exchange loss of $3,279. This loss is due to the exposure of a company to transaction risk.
Transaction risk creates difficulties for individuals and corporations dealing in different
currencies, as exchange rates can fluctuate significantly over a short period of time. This
volatility is usually reduced, or hedged, by entering into currency swaps and other similar
securities.

3. OPERATING RISK:Operating risk is another risk to which a firm is exposed to that results impact on future cash
flows arising from cross-border transactions due to unanticipated change in exchange rate.
The foreign currency receipts and payments resulting from a firms international business,
impacts its operating income, operating cost and operating profits in future. It has a longer
time horizon than transaction risk. The transactions that can lead to such situations are like a
currency has to be converted in order to make or receive payment for goods and servicesexport or import denominated in a foreign currency, remuneration for services being rendered
on foreign land, etc. the foreign currency value of these items are contractually fixed, i.e.,
they do not vary with changing exchange rate. The time of payment or receipt is also fixed.
So, the uncertainty pertains to the change in home currency value.
For example, a firm receives an export order from a buyer in US for goods worth $50,000
with a credit of 90 days. The amount will be received in foreign currency (US $) which will
be converted to domestic currency (INR) and value to be realised should be Rs.31,00,000 as
per the spot rate of Rs.62. the company manufactures the product and incurs expenditure for
it amounting to Rs.29,50,000. However, during the 90 days credit period, there has been a
depreciation of US dollar to Rs. 58. So, the amount actually realised would be Rs.29,00,000.
It may result in reduction of its profit margin or loss due to such situations. Thus, a firm
would need to adopt some operating cost control techniques so as to minimize this risk.