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Which of the following statements are true?  a) Transaction exposure is inherent in all foreign currencies denominated contractual transactions  b) Translation exposure relates to the change in accounting income and balance sheet statements caused by change in exchange rate  c) Economic exposure has an impact on the valuation of a firm  d) Operating exposure does not have any impact on the firm's future operating revenues or future operating costs  Choose the correct option from those below: 

Which of the following statements are true?  a) Transaction exposure is inherent in all foreign currencies denominated contractual transactions  b) Translation exposure relates to the change in accounting income and balance sheet statements caused by change in exchange rate  c) Economic exposure has an impact on the valuation of a firm  d) Operating exposure does not have any impact on the firm's future operating revenues or future operating costs  Choose the correct option from those below:  Correct Answer a), b) and c) only

Though the term risk has got different connotations from different angles, it can be defined as the potential that events, expected or unexpected may have an adverse impact on earnings or capital or both. Risk and expected return are positively related; higher the risk, higher the expected return, and vice versa. 

1. Transaction Exposure: 

  • This arises when a company is importing or exporting.
  • If the exchange rate moves between agreeing on the contract in a foreign currency and paying or receiving the cash, the amount of home currency paid or received will alter, making those future cash flows uncertain.
  • For instance, An Indian person has to make a payment to a person residing in the US after 3 months.
  • Now, since foreign exchange rates are volatile, there is a chance that the Indian currency will weaken or the US currency will strengthen on the day of payment causing a loss to the Indian person. 
  • Transaction exposure is inherent in all foreign currencies denominated contractual transactions.
  • Thus, statement A is correct.


2. Translation Exposure

  • It refers to the amount of risk facing the firm as a result of the need to translate financial statements prepared in one currency into statements in another currency.
  • This is particularly true for multinational firms which must consolidate their financial results at the end of the year.
  • The accounting framework is the legally required form in which companies must report operating results and financial condition to shareholders.
  • The financial statements contain information of interest to various other parties viz lenders, debtors, regulators.
  • Thus, the translation of subsidiary accounts for consolidation into parent accounts faces translation exposure and may pose serious implications for the parent company.
  • For instance, If the subsidiary is in a country whose currency weakens, the subsidiary’s assets will be less valuable in the consolidated accounts.
  • Thus, statement B is correct. 


3. Economic exposure

  • It relates to 'cash flow' risks.
  • Thus, economic exposure has an impact on the valuation of a firm. 
  • Economic (competitiveness) risk is concerned with threats from changes in real exchange rates to the competitiveness of costs.
  • The sensitivity of a business to competitiveness risk depends on its elasticity of demand.
  • Competitiveness risk is a long term problem. For example, the business is a single hotel, and the home currency becomes uncompetitive, fewer tourists will come and the hotel will lose business.
  • Some authors like Adler and Dumas (1984) and Wihlborg (1987) treat currency risk as one element of the wider concept of macroeconomic threats to real (inflation-adjusted) cash flows. 
  • The economic risks may include exchange rate fluctuations, a shift in government policy or regulations, political instability, or the introduction of economic sanctions.
  • Thus, statement C is correct.


4. Operational risk

  • According to the Basel Committee, Operational risk is defined as “the risk of loss resulting from inadequate or failed processes, people and systems or external events.
  •  This risk is associated with human error, system failures, and inadequate procedures and controls.” According to Laylock (1998) “Operational risk is the potential for adverse fluctuations in the profit-and-loss statement or the cash flow of the firm due to effects that are attributable to customers, inadequately defined controls, system or control failures, and unmanageable events.” 
  • Since operating exposure has an impact on the firm's future operating revenues or future operating costs, statement D is incorrect.

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