There are three types of exchange rate risk exposure for a Financial Planner or a Risk manager:-
- Translation exposure
- Transaction exposure
- Economic exposure
Translation exposure is the change in accounting income and balance sheet statements caused by changes in exchange rates. Under the rules of Financial Accounting Standards Board, a US company must determine a functional currency for all and each of its offshore subsidiaries. If such a subsidiary is a stand alone firm with vertical or horizontal integration with the particular country, the functional currency can be the local currency otherwise it has to the dollar.
Transaction exposure is the gain or loss that might occur during settlement of foreign exchange transaction. Such a transaction could be the sale / purchase of product or services lending or borrowing of money or any other transaction involving mergers and acquisitions.
Economic exposure, the most important of the three, is the change in value of a company that accompanies an unanticipated change in the exchange rates. There is a clear distinction between the anticipated and the unanticipated change of exchange rates. The anticipated change has already been factored into the valuation of the company by the market forces. The unanticipated comes as an unforeseen risk.