Currency Risk

Currency risk refers to the impact of changes in currency values on a company's cash flows or overall financial health. The assessment of currency risk is known as "exposure" or "risk exposure." There are two main categories of currency risk exposure: Economic exposure and Accounting exposure.

Economic exposure is related to a company's cash flows and arises from the interplay of operating exposure and the cash-flow elements of transaction exposure. In contrast, accounting exposure concerns a company's assets, liabilities, revenues, and expenses that are expressed in foreign currencies, as shown in its financial statements. This type of exposure results from the combination of translation exposure and the accounting aspects of transaction exposure.

Operating exposure is the risk that fluctuations in exchange rates will affect a company's future operating revenues and costs. A firm faces operating exposure if its competitive position is impacted by changes in exchange rates, even if it does not conduct foreign currency transactions. For example, a ski resort in Chile may experience operating exposure to foreign exchange risk if a devaluation of the Argentine peso prompts customers to choose less expensive options in Argentina.

Transaction exposure evaluates the effect of exchange rate variations on transactions that are denominated in foreign currencies—specifically, sales and purchases that have a contractual agreement. For instance, if an exporter whose functional currency is EUR has a contract to sell goods to a US client in three months, the transaction, priced in USD, introduces currency risk for the EUR cash flow due to fluctuations in the EUR-USD exchange rate during the period from the sale initiation to settlement. When the foreign currency accounts receivable or payable are recorded on the balance sheet, this also leads to accounting exposure.

Translation exposure pertains to the effect of exchange rate changes on the current balance sheet and income statement. It encompasses the foreign currency gains and losses that occur when a company's financial statements are consolidated and the accounts of foreign subsidiaries are converted into the home currency. Translation can be executed by applying the current exchange rate to all balance sheet and income statement items or by utilizing different exchange rates (current/historical) for various assets and liabilities on the balance sheet.