Translation Exposure:

➔ It is the degree to which a firm’s foreign currency denominated financial statements are
affected by exchange rate changes.
➔ translation exposure relates to the change in accounting income and balance sheet
statements caused by the changes in exchange rates. These changes may take place by/at
the time of finalization of accounts compared to the time when the asset was purchased or
liability was assumed.
➔ In other words translation exposure results from the need to translate foreign currency
assets or liabilities into the local currency at the time of finalizing accounts.
➔ If a firm has subsidiaries in many countries, the fluctuations in exchange rate will make
the assets valuation different in different periods.
➔ The changes in asset valuation due to fluctuations in exchange rate will affect the group’s
asset, capital structure ratios, profitability ratios, solvency ratios, etc.
➔ also known as accounting exposure

Transaction Exposure:

➔ This exposure refers to the extent to which the future value of firm’s domestic cash flow
is affected by exchange rate fluctuations.
➔ It arises from the possibility of incurring foreign exchange gains or losses on transaction
already entered into and denominated in a foreign currency. The degree of transaction
exposure depends on the extent to which a firm’s transactions are in foreign currency i.e.
The transaction in exposure will be more if the firm has more transactions in foreign
currency.
➔ The monetary items of a firm, such as receivables and payables, denominated in different
foreign currencies, are exposed to changes in the respective foreign exchange rates
➔ It refers to potential changes in the value of contractual cash flows that arise due to
unexpected changes in the foreign exchange rate. It is a measure of the sensitivity of the
home currency value of assets and liabilities in foreign currency to unanticipated changes
in exchange rates.

EXAMPLE

A company in India has exported goods worth USD 10 million to a U.S. firm, payable three
months from now. At the same time, it has purchased equipment from the same U.S. firm for
USD 5 million, payable in the next three months. The spot rate is USD/INR 42. What is the
transaction exposure of the Indian company? Suppose the INR appreciates against the USD and
the exchange rate becomes USD/INR 41 in the three-month period. What is the transaction loss
to the Indian company?

Solution

● Net exposure in USD = Inflows − Outflows = USD 10 million − USD 5 million = USD 5
million
● Exposure in terms of INR = INR 210 million
● Transaction loss = INR 210 × [(42 − 41)/42] = INR 5 million OR, USD 5 million × (42 −
41) = INR 5 million

Economic Exposure:

➔ Economic exposure is also known as operating exposure operating exposure is a

relatively broader conception of foreign exchange exposure.
➔ Economic exposure refers to potential changes in all future cash flows of a firm that
result from unanticipated changes in exchange rates
➔ Economic exposure refers to the degree to which a firm’s present value of future cash
flows can be influenced by exchange rate fluctuations.
➔ Economic exposure is a more managerial concept than an accounting concept. A
company can have an economic exposure to say Pound/Rupee rates even if it does not
have any transaction or translation exposure in the British currency.
➔ This situation would arise when the company’s competitors are using British imports. If
the Pound weakens, the company loses its competitiveness (or vice versa if the Pound
becomes strong).
➔ Thus, economic exposure to an exchange rate is the risk that a variation in the rate will
affect the company’s competitive position in the market and hence its profits.
➔ Further, economic exposure affects the profitability of the company over a longer time
span than transaction or translation exposure.
➔ Under the Indian exchange control, economic exposure cannot be hedged while both
transaction and translation exposure can be hedged
➔ Although the value of a firm is exposed to both real and nominal changes in exchange
rates, it is the changes in the real exchange rate that have significant economic
implications for the relative competitiveness of exporters as well as importers.