Exchange Risk Foreign exchange risk is the possibility of a gain or loss to a firm that occurs due to unanticipated changes

in exchange rate. Types of Exposure Translation Exposure It is the degree to which a firms foreign currency denominated financial statements are affected by exchange rate changes. All financial statements of a foreign subsidiary have to be translated into the home currency for the purpose of finalizing the accounts for any given period. 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 groups asset, capital structure ratios, profitability ratios, solvency ratios, etc. FASB 52 specifies that US firms with foreign operations should provide information disclosing effects of foreign exchange rate changes on the enterprise consolidated financial statements and equity. The following procedure has been followed: 1. Assets and liabilities are to be translated at the current rate that is the rate prevailing at the time of preparation of consolidated statements. 2. All revenues and expenses are to be translated at the actual exchange rates prevailing on the date of transactions. For items occurring numerous times weighted averages for exchange rates can be used. 3. Translation adjustments (gains or losses) are not to be charged to the net income of the reporting company. Instead these adjustments are accumulated and reported in a separate account shown in the shareholders equity section of the balance sheer, where they remain until the equity is disposed off. Measurement of Translation Exposure Translation exposure = (exposed assets - exposed liabilities) (change in the exchange rate) Transaction Exposure This exposure refers to the extent to which the future value of firms 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 firms transactions are in foreign currency. For example, the transaction in exposure will be more if the firm has more transactions in foreign currency.

According to FASB 52 all transaction gains and losses should be accounted for and included in the equitys net income for the reporting period. Unlike translation gains and loses which require only a bookkeeping adjustment, transaction gains and losses are realized as soon as exchange rate changes. The exposure could be interpreted either from the standpoint of the affiliate or the parent company. An entity cannot have an exposure in the currency in which its transactions are measured. Economic Exposure It refers to degree to which a firms 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 companys 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 companys 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.