8 Definitions of foreign
exchange risk
Foreign exchange risk management begins by identifying what items and amounts a
firm has exposed to risk associated with changes in exchange rates. An asset, liability,
profit or expected future cash flow stream (whether certain or not) is said to be exposed
to exchange risk when a currency movement would change, for better or for worse,
its parent or home currency value. The term ‘exposure’ used in the context of foreign
exchange means that a firm has assets, liabilities, profits or expected future cash flow
streams such that the home currency value of assets, liabilities, profits or the present
value in home currency terms of expected future cash flows changes as exchange
rates change. Risk arises because currency movements may alter home currency values.
In this sense, assets, liabilities and expected future cash flow streams denominated
in foreign currencies are clearly exposed to foreign exchange risk. But some expected
future cash flows denominated in home currency terms may also be exposed. For
example, a UK company selling in its home market may be competing with firms
based in the Netherlands. In such circumstances changes in the sterling/guilder
exchange rate will almost certainly affect the present value of the UK company’s
expected cash flows by strengthening or weakening its competitive position against
its Dutch rivals.
Foreign exchange exposure is usually classified according to whether it falls into
one or more of the following categories:
n transaction exposure;
n translation exposure;
n economic exposure.
Transaction exposure arises because a payable or receivable is denominated in
a foreign currency. Translation exposure arises on the consolidation of foreign-
currency-denominated assets and liabilities in the process of preparing consolidated
accounts. This concept is essentially concerned, then, with what might be called
accounting exposure. Economic exposure arises because the present value of a
stream of expected future operating cash flows denominated in the home currency
or in a foreign currency may vary because of changed exchange rates. Transaction
and economic exposure are both cash flow exposures. Transaction exposure is a
comparatively straightforward concept but translation and economic exposure are
more complex. Each of the three categories of exposure is now examined and defined
in more detail.
136 Chapter 8. Definitions of foreign exchange risk
8.1 y Transaction exposure
Transaction exposure arises because the cost or proceeds (in home currency) of
settlement of a future payment or receipt denominated in a currency other than the
home currency may vary because of changes in exchange rates. Clearly transaction
exposure is a cash flow exposure. It may be associated with trading flows (such as
foreign-currency-denominated trade debtors and trade creditors), dividend flows or
capital flows (such as foreign-currency-denominated dividends or loan repayments).
8.2 y Translation exposure
Consolidation of financial statements that involve foreign-currency-denominated
assets and liabilities automatically gives rise to translation exposure, sometimes
termed accounting exposure. Consolidation of foreign subsidiaries’ accounts into
group financial statements denominated in home currency requires the application of
a rate or rates of exchange to foreign subsidiaries’ accounts, in order that they may
be translated into the parent currency. Both balance sheets and income statements
must be consolidated and they both give rise to translation exposure. Translating
foreign currency profit and loss accounts at either the average exchange rate during
the accounting year or at the exchange rate at the end of the accounting year (both
methods are currently permissible UK accounting procedures) will mean that
expected consolidated profit will vary as the average or the expected closing rate
changes. So the whole amount of profit earned in foreign currency is exposed to
translation risk in the sense that the home currency consolidated profit may vary as
exchange rates vary.
Balance sheet exposure is somewhat more complex. Some items in a foreign sub-
sidiary’s balance sheet may be translated at their historical exchange rates (the rate
prevailing at the date of acquisition or any subsequent revaluation). Thus their home
currency translated value cannot alter as exchange rates alter; such assets and liab-
ilities are not exposed in the accounting sense. Other items may be translated at the
closing exchange rate – the rate prevailing at the balance sheet date at the end of the
accounting period. While the value of such items is fixed in the foreign subsidiary’s
currency, the amount translated into the parent currency will alter as the exchange
rate alters. Hence all foreign currency items that are consolidated at current rates are
exposed in the accounting sense.
Accounting exposure, therefore, reflects the possibility that foreign-currency-
denominated items which are consolidated into group published financial statements
at current or average rates will show a translation loss or gain as a result. This kind
of exposure does not give an indication of the true effects of currency fluctuations on
a company’s foreign operations.
Economic exposure, to be discussed later, is a far better measure of true value
exposure. Translation exposure, as will become clear later, is really a function of the
Chapter 8. Definitions of foreign exchange risk 137
system of accounting for foreign assets and liabilities on consolidation which a group
of companies uses. Clearly it has little to do with true value in an economic sense.
There are four basic translation methods. These are the current/non-current
method (sometimes called the traditional or working capital method), the all-current
(or closing rate) method, the monetary/non-monetary method, and the temporal
method. These differing means of translation are considered in detail below. It is
worth mentioning that the all-current method is now the most frequently used in the
United Kingdom, the United States and many other countries.
The current/non-current method
This approach uses the traditional accounting distinction between current and long-
term items and translates the former at the closing rate and the latter at the histor-
ical rate. Accounting exposure for a foreign subsidiary at a particular point in time
is given by the net figure of assets less liabilities that are exposed to potential change
should exchange rates alter. Evidently, according to the current/non-current method,
the sum exposed is net current assets.
One of the implications of this method of translation is that inventory is exposed
to foreign exchange risk but long-term debt is not. The logic of such an assumption
is by no means apparent. Indeed it should be clear that long-term debt is very much
exposed to exchange risk. In home currency terms, the cash amount of a foreign-
currency-denominated loan (whether a payable or receivable loan) will change as
exchange rates change. This lack of logic underpins the move away from the
current/non-current method which has been witnessed over recent years.
The all-current (closing rate) method
This method merely translates all foreign-currency-denominated items at the closing
rate of exchange. Accounting exposure is given simply by net assets or shareholders’
funds (sometimes called equity). This method has become increasingly popular over
time and is now the major worldwide method of translating foreign subsidiaries’
balance sheets.
The monetary/non-monetary method
Monetary items are assets, liabilities or capital, the amounts of which are fixed by
contract in terms of the number of currency units regardless of changes in the value
of money. Translation via the monetary/non-monetary method involves monet-
ary assets and monetary liabilities being translated at the closing rate while non-
monetary items are translated at their historical rate. Accounting exposure under this
method is given by net monetary assets.
In terms of development of accounting reporting, this method of translating for-
eign subsidiaries’ accounts seems to have been a halfway house between the current/
non-current method and the all-current method.
138 Chapter 8. Definitions of foreign exchange risk
The temporal method
The temporal method of translation uses the closing rate method for all items stated
at replacement cost, realizable value, market value or expected future value, and uses
the historical rate for all items stated at historic cost.
The rationale for the temporal approach is that the translation rate used should
preserve the accounting principles used to value assets and liabilities in the original
financial statements. According to the temporal method, the translation rate for each
asset or liability depends upon the measurement basis used in the foreign subsidiary’s
original account.
Applied to traditional historic cost accounts, the temporal and monetary/non-
monetary methods give almost the same results. The main difference arises in the
case of certain items of inventory. Where stock is stated in the original accounts at
market value (where it is below historic cost) the temporal method would translate
it at the current rate while the monetary/non-monetary approach would use the his-
toric rate of exchange. But it should be emphasized that the temporal method is by
no means synonymous with the monetary/non-monetary approach.
Example 1 – a numerical example
It should be clear that identical firms with identical assets, liabilities, capital struc-
tures and trading results may show different translation gains and losses and dif-
ferent translated balance sheets depending upon the method used for converting
foreign currency items to home currency values. This can be demonstrated by a
simple numerical example.
Assume that a UK company sets up a subsidiary in Australia on 1 March and
that the opening transactions are booked in the Australian company’s accounts
according to the prevailing exchange rate of £1 = AUD3. The opening balance
sheet is shown in Table 8.1.
Assume, further, that no additional business or transactions go through the
Australian company during March and consequently the Australian dollar balance
sheet at the end of the month remains as at the beginning. But assume that dur-
ing March sterling fell against the Australian dollar and the exchange rate at the
end of the month was £1 = AUD2.5. This means that the sterling-translated bal-
ance sheet of the subsidiary will alter, the extent of the change differing according
to whether the current/non-current, all-current, or monetary/non-monetary method
of translation is used. Table 8.1 shows the results.
From the table it will be noted that the translation gain or loss is equal to 16.67
per cent of the accounting exposure. This is, of course, consistent with the move-
ment in sterling value versus the Australian dollar from 3 to 2.5. But it will further
be noted from the table that translation outturns range from a gain of over
£491,000 to a loss of over £349,000. These differences arise merely because of
varying accounting methods.
Chapter 8. Definitions of foreign exchange risk
Table 8.1 Example illustrating translation exposure
Subsidiary’s balance sheet as at
31 March translated according to:
Subsidiary’s balance Subsidiary’s balance Current/ Monetary/
sheet as at 1 March sheet as at 1 March All-current rate non-current non-monetary
AUD000 £000 £000 £000 £000
Fixed assets 8,400 2,800 3,360* 2,800 2,800
Inventory 4,200 1,400 1,680* 1,680* 1,400
Cash 1,065 355 426* 426* 426*
Total assets 13,665 4,555 5,466 4,906 4,626
Current payables 2,100 700 840* 840* 840*
Long-term debt 4,200 1,400 1,680* 1,400 1,680*
Equity 7,365 2,455 2,946 2,666 2,106
Translation gain/(loss) 491 211 (349)
Accounting exposure as at
31 March exchange rate 2,946 1,266 (2,094)
But accounting exposure is
better measured in foreign
currency as AUD000 7,365 3,166 (5,234)
* Assets and liabilities exposed, as of 31 March, to translation exposure under different translation conventions.
139
140 Chapter 8. Definitions of foreign exchange risk
Example 2 – moving towards a consensus
Internationally, the accounting profession has been concerned about the position
on translation of foreign-currency-accounting statements. Indeed, the accounting
professions in the United States and the United Kingdom now have almost ident-
ical rules for accounting for foreign currencies in published accounts. Generally
speaking, translation of foreign balance sheets uses the current rate method.
Transaction gains, whether realized or not, are accounted for through the profit
and loss account. But there is a major exception. Where a transaction profit or loss
arises from taking on a foreign currency borrowing in a situation in which the bor-
rowing can be designated as a hedge for a net investment denominated in the
same foreign currency as the borrowing, then the gain or loss on the borrowing, if
it is less than the net investment hedged, would be accounted for by movements
in reserves rather than through the income statement. If this kind of transaction
gain or loss exceeds the amount of the loss or gain respectively on the net
investment hedged, the excess gain or loss is to be reported in the profit and
loss account. Non-transaction gains and losses are to be dealt with by reserve
accounting direct to the balance sheet rather than through the profit and loss
account.
According to the US standard FAS 52, translation of foreign currency revenues
and costs (the essence of the income statement) is to be made at the average
exchange rate during the accounting period. The British standard SSAP 20 allows
the use of either the current rate or the average rate for this purpose. However, it
is fair to say that opinion in the United States has moved towards the average rate
method.
While translation methods affect group balance sheet values, the key point is
that they have nothing to do with economic value. The value of the Australian sub-
sidiary in the example should not be affected by adopting a different method of
accounting. Its worth will be the same whether the all-current, current/non-current
or monetary/non-monetary method is used. In all probability its discounted net
present value will have changed as a result of the strengthened guilder. But this
changed present value is hardly what we pick up by using different methods of
translating balance sheets. Clearly, changes in value resulting from changed
exchange rates show in terms of different present values. If we are concerned with
how true value has changed because of exchange rate movements, we should be
looking at economic value and how it changes in sympathy with moving exchange
rates. This is what true exposure to exchange rate movements is all about.
Chapter 8. Definitions of foreign exchange risk 141
8.3 y Economic exposure
Economic exposure is concerned with the present value of future operating cash
flows to be generated by a company’s activities and how this present value, expressed
in parent currency, changes following exchange rate movement. The concept of
economic exposure is most frequently applied to a company’s expected future oper-
ating cash flows (unhedged) from sales in foreign currency and from foreign opera-
tions. But it can equally well be applied to a firm’s home territory operations and
the extent to which the present value of those operations alters resultant upon
changed exchange rates. For the purpose of convenience, the exposition that follows
is based on a firm’s foreign operations, although an uncovered foreign-currency-
denominated receivable or payable will vary as exchange rates vary.
The value of an overseas operation can be expressed as the present value of
expected future operating cash flows which are incremental to that overseas activity
discounted at the appropriate discount rate. Expressing this present value in terms of
the parent currency can be achieved via equation (8.1) – but remember that incre-
mental cash flows to the whole group of companies include management fees, royalt-
ies and similar kinds of flow as well as direct cash flows from trading operations. The
present value of the foreign subsidiary may be expressed as:
n
(CIt − COt )et
PV = ∑ (8.1)
t =0 (1 + r)t
where PV is the parent currency present value of the foreign business, CI represents
estimated future incremental net cash inflows associated with the foreign business
expressed in foreign currency, CO is the estimated future incremental net cash
outflows associated with the foreign business expressed in foreign currency, e is the
expected future exchange rate (expressed in terms of the direct quote in the home ter-
ritory), r is the appropriate discount rate, namely the rate of return that the parent
requires from an investment in the risk class of the overseas business, t is the period
for which cash flows are expected and n is the final period for which all flows are
expected. Equation (8.1) assumes that all net incremental cash flows accruing to the
overseas operation are distributable to the parent company in the home country.
At first sight the reader might conclude that quantifying economic exposure and
the impact of changing exchange rates is fairly straightforward. For example, assume
that a UK company has a wholly owned Danish subsidiary with a net present value
of DKK120m. If the exchange rate is £1 = DKK8 and subsequently moves to £1 =
DKK10, presumably the value of the subsidiary has moved from £15m to £12m.
Such a conclusion would, in all probability, be incorrect. It is necessary to be far
more analytical to reach a worthwhile conclusion on valuation.
Devaluation will affect cash inflows and cash outflows as well as the exchange
rate. Consider a company competing in export markets. While devaluation will not
affect the total market size, it should have a favourable market share effect. The com-
pany in the devaluing country should increase sales or profit margins – in short, it
should benefit. Similarly, companies competing with imports in the domestic market
should also gain since a devaluation will tend to make imported products more
142 Chapter 8. Definitions of foreign exchange risk
expensive in local currency terms. However, this benefit may be offset to some extent
by domestic deflation which frequently accompanies devaluation. So, in the import
competing sector of the domestic market there will be beneficial and negative
impacts. Next, in the purely domestic market, devaluation may lead to reduced com-
pany performance in the short term as a result of deflationary measures at home
which so often accompany currency depreciation.
All of the above factors affect cash inflows. Devaluations also affect cash outflows.
Imported inputs become more expensive. If devaluation is accompanied by domestic
deflation it will probably be the case that suppliers’ prices will rise as their financing
costs move up. An inverse line of reasoning applies with respect to revaluation of a
currency.
Getting to grips with economic exposure involves us in analysing the effects of
changing exchange rates on the following items:
n Export sales, where margins and cash flows should change because devaluation
should make exports more competitive.
n Domestic sales, where margins and cash flows should alter substantially in the
import competing sector.
n Pure domestic sales, where margins and cash flows should change in response to
deflationary measures which frequently accompany devaluations.
n Costs of imported inputs, which should rise in response to a devaluation.
n Cost of domestic inputs, which may vary with exchange rate changes.
The analysis is clearly complex, but it is necessary in order to assess fully how the
home currency present value of overseas operations is likely to alter in response to
movements in foreign exchange rates.
So far it has been assumed that the parent’s present value of its foreign subsidiary
is a function of that subsidiary’s estimated future net cash flows. In other words,
there is an assumption that all cash flows are distributable to the parent. In fact, host
governments frequently restrict distribution to foreign parents by exchange controls.
Suffice here to say that where distribution of cash flows to the parent is limited, the
present value formula needs to be adjusted a little:
n
(Divt + OPFt )et TVe n
PV = ∑ + (8.2)
t =0 (1 + r) t
(1 + r)n
The notation is as before except that Div represents the expected net dividend inflow
in a particular year, OPF represents other parent flows such as royalties and man-
agement fees in a particular period, and TV represents the terminal value remittable
over the foreign exchanges at the end of the project’s life.
The reader should always bear in mind that economic exposure is equally applic-
able to the home operations of a firm inasmuch as a change in exchange rates is
likely to affect the present value of its home operations; this may arise for all of the
reasons which would impinge upon foreign businesses.
There is another, related dimension to economic exposure. A UK firm exporting
goods to the United States, denominated in dollars, in competition with a German
Chapter 8. Definitions of foreign exchange risk 143
manufacturer will be facing a transaction exposure against the dollar and an eco-
nomic exposure against the euro. Clearly, as the exchange rate between the pound
and the euro changes, so the UK manufacturer is in a stronger or weaker position
and this will filter through to sales levels, profit and cash generation. As such, the
present value of the UK company’s export business will alter as exchange rates
change. Just like the previous kind of economic exposure, this subset is difficult to
quantify for reasons similar to those mentioned before.
It can be seen that assessing economic exposure necessarily involves us in a sub-
stantial amount of work on elasticities of demand and behaviour of costs in response
to changes in exchange rates. But the critical question that we would ask is whether
economic exposure (or transaction exposure or translation exposure for that matter)
is of any relevance to the financial manager of an international company. This ques-
tion is addressed in Chapter 10.
8.4 y Summary
n Foreign exchange risk concerns risks created by changes in foreign currency
levels.
n An asset, liability or profit or cash flow stream, whether certain or not, is said
to be exposed to exchange risk when a currency movement would change, for
better or worse, its parent, or home, currency value.
n Exposure arises because currency movements may alter home currency values.
n Categorizations of foreign currency exposure vary from text to text. This chap-
ter distinguishes three forms of currency risk. These are transaction exposure,
translation exposure and economic exposure. Later, in Chapter 11, a further
classification, macroeconomic exposure, is highlighted. But we shall leave this
to one side for the moment. In any case it is really more than foreign exchange
exposure.
n Transaction exposure arises because a payable or receivable is denominated in a
foreign currency.
n Translation exposure (sometimes also called accounting exposure) arises on the
consolidation of foreign-currency-denominated assets, liabilities and profits in
the process of preparing accounts.
n Economic exposure arises because the present value of a stream of expected
future operating cash flows denominated in the home currency or in a foreign
currency may vary because of changed exchange rates.
n Note that transaction and economic exposure are both cash flow exposures. Pure
translation exposure is not cash flow based.
n A particular item may be classified under more than one heading. For example,
a long-term foreign-denominated borrowing is both a transaction exposure
144 Chapter 8. Definitions of foreign exchange risk
(because the home currency equivalent to repay the loan varies as exchange rates
change) and a translation exposure.
n The magnitude of a translation exposure varies according to the accounting con-
vention used for translation of foreign-denominated items. There are four basic
translation methods. These are the current/non-current method, the all-current
(sometimes called closing rate) method, the monetary/non-monetary method,
and the temporal method. The exact mechanisms by which each method works
are summarized in the main text.
n It is worth noting that, nowadays, most advanced economies, including the
United States and the United Kingdom, consolidate foreign-denominated balance
sheet items according to the all-current method. These countries tend to use
either the closing rate or the average rate during an accounting period for the
purpose of translating foreign-denominated profit and loss accounts.
n The relevance of classifying foreign exchange risk according to its transaction,
translation or economic nature is that we would advocate that some categories
of exposure should be actively managed by the headquarters treasury while our
prescription for other categories is that since some of them do not matter, there
is little point in applying treasury time in taking action to avoid the risk con-
cerned – more of this later.
8.5 y End of chapter questions
Question 1
Compare and contrast transaction exposure and economic exposure.
Question 2
Why might the cash flows of purely domestic firms be exposed to exchange rate
fluctuations?
Question 3
How do most companies deal with economic exposure?