Transaction and Translation Exposure

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Le ctu Pr of. re Az by ar m i Transaction Exposure What are the two major forms of currency risks that a company with subsidiaries in foreign countries faces? Transaction (or contractual) exposure Translation exposure Le ctu Pr of. re Az by ar m i What is transaction exposure? It refers to gains and losses that may be incurred, when monetary transactions are settled in a foreign currency. Le ctu Pr of. re Az by ar m i Example of transactions exposure? -A company buys (or sells) on credit a product that is priced in a foreign currency. -A firm borrows (or lends) in a foreign currency. Le ctu Pr of. re Az by ar m i A British company buys cars from a German firm -Total contract price Euros 1,000,000 -Payment due in 90 days -Exchange rate Euros 2 / BP 1 The British firm owes Euros 1,000,000/ Euros 2 / BP 1 = BP 500,000 Le ctu Pr of. re Az by ar m i In 90 days the exchange rate may change to Euro 2.05 / BP 1 Then the British firm owes Euro 1,000,000/ Euro 2.05 / BP 1 = 487,805 BP The dealer saves 12,195 BP due to transaction exposure Le ctu Pr of. re Az by ar m i In 90 days the exchange rate may also change to Euro 1.95/ BP 1 Then the British firm owes Euro 1,000,000/ Euro 1.95 / BP 1 = 512,821 BP The dealer pays an extra 12,821 BP due to transaction exposure Le ctu Pr of. re Az by ar m i What is the German firm’s exposure? None, it gets paid in EURO and all its costs are in EURO. Le ctu Pr of. re Az by ar m i Should the British firm demand that the German firm somehow make up for its transaction exposure? Yes. Risk is costly to bear. After all, the German firm may write the sales contract for 500,000 British Pounds. The British firm should consider the transaction risk exposure as a cost item in addition to the cost of

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