Foreign exchange exposure may be classified into three broad types:
1. Transaction exposure
2. Translation exposure
3. Economic exposure
When a form has a payable or receivable denominated in a foreign currency a change in the exchange rate will alter the amount of local currency received or paid. Such a risk or exposure is referred to as transaction exposure. For example, if an Indian exporter has a receivable of $100,000 due three months hence, and if in the meanwhile the dollar depreciates relative to the rupee, a cash loss occurs. Conversely, if the dollar appreciates relative to the rupee, a cash gain, occurs. In the case of payable, the outcome is of an opposite kind: a depreciation of the dollar relative to the rupee results in a gain, whereas an appreciation of the dollar relative to the rupee results in a loss.
The laws in many countries require that the accounts of foreign subsidiaries and branches have to be consolidated with those of the parent company. For such consolidation, assets and liabilities expressed in foreign currencies have to be translated into domestic currency at the exchange rate prevailing on the consolidation date. If the value of a foreign currency changes between two successive consolidation dates, translation gains or losses arise.
Indian laws presently do not require consolidation of the accounts of foreign subsidiaries of branches with those of the parent firm in India. So the kind of translation exposure described above is not relevant for Indian firms. However, borrowings in foreign currencies do result in translation exposure. The Income Tax Act requires that foreign currency liabilities are marked to market at the exchange rate prevailing on the date of casting the balance sheet. If the rupee liability increases (decreases) on account of such revaluation, the value of the fixed asset which is financed by the foreign currency borrowing is correspondingly increased (decreased). Depreciation is admissible on such revalued assets.
Economic exposure like transaction exposure, involves an actual or potential gain or loss. While the former is specific to a transaction the latter much broader in nature, relates to an entire investment. The essence of economic exposure is that exchange rate change significantly alters the cost of a firm’s inputs and the prices of its output and thereby influence its competitive position substantially. An example may be given to explain this concept. Volkswagen had a highly successful export market for its Beetle model in the US before 1970. With the breakdown of the Brettonwoods system of fixed exchange rates, the Deutschemark appreciated significantly against the dollar. This created problems for Volkswagen as its expenses were mainly in Deutschemark but its revenues in dollars. To protect its profit margin in Deutschemark, the company raised its prices in dollars. However, in a highly price sensitive US market such an action caused a sharp decrease in sales volume from 600,000 vehicles in 1968 to 200,000 in 1976 (Incidentally, Volkswagen’s 1973 losses were the highest, as of that year, suffered by any company anywhere in the world).
It will be useful for the exporter to know the various factors that influence the exchanges rates. By a study of these factors and the trend of movements in the value of a particular currency, an experienced businessman may be able to forecast the possible future movement of that currency This will enable him to determine whether it would be worthwhile for him to carry the risk.
Primary determinants: (1) Demand and supply of a particular currency are the most important factors affecting its exchange rate. In general, if a country has an import surplus, its exchange rate is likely to depreciate; in case of export surplus, the rate is likely to go up. There are three classes of transactions on the foreign exchange market; purchases and sales for trading purposes speculative deals by professional dealers and protective movements by substantial holders. Professional dealers are willing to buy or sell currencies according to their estimate of that the future exchange rate is likely to be from those who want to sell or buy to hedge their position or eliminate the speculative elements in their transactions.