There are 3 types of exposures
existing in a foreign exchange market.
1.
transaction exposure
transaction exposures are the
most common. Suppose that a company is exporting in euro and, while costing the
transaction, materializes, i.e.the export is effected and the euros sold for
rupees, the exchange rate has moved to rs. 40 per euro. In this case, the
profitability of the export transaction can be completely wiped out by the
movement in the exchange rate. This is termed as the transaction exposure which
arises whenever a business has forein currency denominated receipts or
payments.
2.
translation exposure
translation exposure arise from
the need to translate foreign currency assets or liabilities into the home
currency for the purpose of finalizing the accounts for any given period. A
typical example of a translation exposure is the treatment of foreign currency
loans.
Consider that a company has
taken a medium term dollar loan to finance the import of capital goods worth $
1mn. When the import materialized, the exchange rate was rs. 40 per dollar. The
imported fixed asset was, therefore, capitalized in the books of company at rs.
400 lacs, for finalizing its accounts for the year in which asset was
purchased. However, at the time of finalization of accounts, exchange rate has
moved to rs, 45 per dollar, involving translation loss of rs. 50 lacs, in this
case, under the income tax actg, the loss cannot be written off ; it has to be
capitalized by increasing the book value of fixed asset purchased by drawing
upon the loan. The book value of asset thus becomes rs. 450 lacs and
consequently higher depreciation will have to be provided for thus reducing the
net profit. If the foreign currency loan is used for working capital. In that
case the entire transaction loss would have to be debited to profit and loss
a/c in the year in which it occurs.
The effect of transaction and
translation exposure could be positive as well if the amount is favourable. The
translation exposure of coursse becomes a transaction exposure at some stage
the dollar loan has to be repaid by u8ndertaking the transation of purchasing
dollars against rupees.
3. ECONOMIC EXPOSURE
both transaction and
translation exposures are accounting concepts whereas economic exposure is
different than an accounting concept. A company could have an economic exposure
to the euro ; rupee rate even if it does not have any transaction or
translation I euro currency ; this will
be the case when its competitors are using European imports. If the euro
weakens, the company loses its competitiveness against the competitors and vice
versa. Generally, all businesses have economic exposures to exchange rates.
Economic exposure to an exchange rate is the risk that a change in the rate
affects the company’s competitive position in the market, or costs, and hence
indirectly, its bottom line. Thus, economic exposures affects the profitability
over a longer time span than transaction exposure.
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