Types of Foreign Exchange Exposure for Businesses
Currency exposure is a risk that many companies face in today's global economy which can impact their bottom line. Businesses may be exposed to currency risk in different ways; however, typically three types of currency exposure tend to occur. This is economic exposure, transaction exposure, and translation exposure.
Economic exposure
This is the exposure that arises from the impact of currency fluctuations on a company's future cash flows and competitiveness.
An example of economic FX exposure is a tour operator in the travel sector that generates a significant portion of its revenue from bookings made in a foreign currency, such as the Euro. If the Euro strengthens against the company's domestic currency, it could lead to a decrease in the company's profitability as it may have to increase prices to compensate for the unfavourable exchange rate. On the other hand, if the Euro weakens, the company may become more competitive as it could offer lower booking prices relative to competitors.
Companies can manage economic FX exposure by using financial hedging techniques, such as hedging programmes that involve forward contracts or options, to hedge against the impact of currency fluctuations on their future cash flows.
Transaction exposure
This type of currency exposure happens when a company engages in a business transaction that involves foreign currency.
This exposure arises due to the difference in time between the moment when a company is entitled to receive cash from a foreign customer and the actual receipt of the cash. Similarly, if a company is required to pay in a foreign currency, the time between the placement of the purchase order and the settlement of the invoice can also expose the company to transaction risk.
For example, an engineering company based in the United Kingdom has won a contract to provide services to a company in the United States. The contract is worth £1 million, and the payment will be received in 12 months. During the next 12 months, fluctuations in the exchange rate between GBP and USD can affect the company's profits.
To manage this risk, companies can use techniques such as hedging, which involves using financial instruments like forward contracts or options to lock in an exchange rate for a time period (e.g., 12 months). By hedging their foreign currency exposure, they can protect their profit margins and avoid losses due to exchange rate fluctuations.
Translation exposure
This occurs when a company has assets or liabilities denominated in a foreign currency that must be translated into their home currency for financial reporting purposes. Fluctuations in the exchange rates can impact the company's financial position and performance.
Let's assume that a European-based company has a subsidiary located in Japan, which reports its financial statements in Japanese Yen (JPY). However, the parent company reports its financial statements in euros (EUR). In order to fulfill its reporting obligations, the parent company needs to convert the financial statements of its Japanese subsidiary from JPY into EUR.
If the EUR/JPY exchange rate fluctuates, with the EUR appreciating against the JPY, the translation of the Japanese subsidiary's financial statements from JPY into EUR would lead to a higher consolidated net income for the parent company. Conversely, if the EUR depreciates against the JPY, the translation will result in a lower consolidated net income for the parent company.
To mitigate translation exposure, companies can use methods such as balance sheet hedging with forward contracts or currency swaps. The choice of strategy depends on a company's specific circumstances.
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We would be delighted to assist you in identifying your risks and determining the most appropriate products and strategies to mitigate them. As a specialist in foreign exchange, Centura FX can offer the products mentioned to meet your FX requirements.
To contact us, please either call 0203 871 9830 or send an email to info@centurafx.com.