Translation Risk

From CEOpedia | Management online

The Translation  risk, also known as foreign exchange or exchange rate risk, can be defined as the possibility that a given receivable may decrease or increase as a result of changes in foreign exchange rates [1]. The occurrence of exchange rate risk causes that the company, which settles in foreign currencies must take into account various types of threat. The lack of a stable level of exchange rate may affect the company in various ways [2]. Such exchange rate fluctuations have a significant impact on the revenues gained by the exporter from the sale of services and goods, the prices incurred by the importer for the purchase of goods on the international market or the raw materials necessary for the production of the goods, which are imported [3]. Currency risk affects the possibility of appearance of smaller receivables or larger liabilities. Foreign exchange risk is often related to the cost of a loan, which companies are obliged to pay back. Differences in interest rates on loans denominated in PLN and foreign currencies contributed to the fact that many enterprises benefit from foreign currency loans, i.e. in the economy: translation risk related to the possibility of fluctuations in the exchange rate of one currency against another [4]. Foreign exchange rate fluctuations may lead to both a worsening of an entity's financial standing and an improvement in its financial standing. The source of risk is the fact that it is impossible to accurately predict the direction and scale of exchange rate fluctuations [5]. Translation risk includes purchase and sale transactions of future periods balance sheet items denominated in foreign currency physical, actual purchases and sales of services and goods not yet invoiced accounts and payments in foreign currencies, which arise when a commercial transaction takes place [6]. In practice, two types of this risk can be distinguished [7]:

  • transaction risk, which occurs when a transaction is settled in a currency other than the enterprise's domestic currency;
  • accounting risk, resulting from the possibility of changing the valuation of assets or liabilities whose price is denominated in a currency other than the currency in which the enterprise maintains its books.

Transaction risk

The essence of the transactional risk is easiest to understand in import and export transactions. In such cases, one of the parties to the transaction is settled in a foreign [8]. The risk is related to the possibility of changing the exchange rate between the trade date and the date on which payment is received. From the perspective of a company settling in a foreign currency, depending on exchange rate fluctuations, the national currency price at the time of payment may be lower or higher than the national currency price at the time of transaction [9].

Accounting risk

Accounting risk is related to holding in the balance sheet assets or liabilities whose value is expressed in a foreign currency. A change in the exchange rate makes it necessary to change their accounting valuation [10]. Attention should be paid to the fundamental difference between transaction risk and accounting risk. In the case of transaction risk, the company directly experiences the effects of risk materialisation (by increasing/decreasing its cash flow in the domestic currency). In the case of accounting risk, however, the risk remains unrealised as long as the company does not enter into any transaction that would be valued in a foreign currency [11]. In other words, the risk materialises at the time of the transaction (i.e. the generation of a cash flow whose value in the domestic currency depends on the exchange rate). It is worth noting that, according to accounting rules, even unrealised gains or losses resulting from changes in exchange rates should be reflected in changes in the company's own funds [12].

Forms of translation risk

Depending on the situation, the exchange rate and currency risk may occur in three forms [13]:

Translation risk factors

The economic risk depends on many factors, including [14]:

  • The geographical location of the company's subsidiaries,
  • the currencies in which the undertaking bears the costs,
  • the geographical location of competitors,
  • relative movements of exchange rates.

Other factors giving rise to exposure are also actual contracted receipts and payments, and orders and offers, i.e. transactions that are likely to occur with a high degree of probability. Each firm should therefore apply a case-by-case approach to hedge its trading exposure, taking into account its market position and the credibility of its counterparties [15]. Transaction risk is the risk that the value of a commercial transaction denominated in a domestic currency will change as a result of changes in exchange rates between the time the transaction is concluded and the time at which the foreign currency is translated into the domestic currency. They affect companies that export or import services and goods, are active in international markets and carry out not only commercial but also investment and credit transactions in foreign currencies [16]. Changes in exchange rates may significantly reduce the profitability of the contract, affecting the deterioration of financial results of the company [17]. If the national currency appreciates against the foreign currency, the exporter will suffer a loss as a result of a reduction in the level of receivables converted into the national currency: the situation is similar for an importer whose national currency is depreciated [18].

Possibility to protect against translation risk

Uncertainty about the value of future cash flows expressed in their own currency is a serious problem for companies. Therefore, a number of financial instruments are used in economic practice to minimise exchange rate risk. The most important of these are [19]:

  • Forward contract - under which the parties to a transaction agree that at a specific moment in the future they will buy/sell a specific currency amount at a specific exchange rate (a specific type of forward contract is a forward contract);
  • Currency option - under which one party to the transaction, for a specific remuneration (the so-called option premium), acquires the right to buy / sell in the future to the other party to the transaction a specific currency amount at a predetermined exchange rate;
  • Currency swap - a transaction between two entities, consisting in the exchange of financial streams in two different currencies, the value and dates of which are fixed in advance.

Author: Justyna Wieczorek

Examples of Translation Risk

  • Foreign exchange (FX) risk arises when a company has cash flows or investments denominated in a foreign currency. For example, a company based in the United States may have receivables or investments denominated in Euros. If the exchange rate between the U.S. Dollar and the Euro were to change, then the value of the receivables or investments would also change.
  • Translation risk can also be seen when a company has subsidiaries in foreign countries. For example, a U.S. company may have subsidiaries in China, Japan, and France. If the exchange rate between the U.S. Dollar and each of these foreign currencies were to change, then the value of the company’s investments in these countries would also change.
  • Finally, translation risk can also be seen when a company has significant cross-border investments or activities. For example, a company based in the United States may have investments in other countries such as China, Japan, and France. If the exchange rate between the U.S. Dollar and each of these foreign currencies were to change, then the value of the company’s investments in these countries would also change.

Advantages of Translation Risk

Translation Risk can provide important advantages to businesses with international operations. Here are some of the key benefits:

  • It can help to diversify a company’s portfolio and reduce the overall risk associated with investments in foreign markets.
  • It can provide a way to hedge against currency fluctuations and help to reduce the impact of volatile exchange rates.
  • It can help to protect profits by locking in favorable exchange rates and reducing losses due to unfavorable rates.
  • It can also be used as a tool to increase profits by taking advantage of favorable exchange rate movements.
  • It can provide an opportunity to gain a competitive edge by exploiting favorable exchange rate movements.

Limitations of Translation Risk

Translation risk can be a significant factor for businesses with operations or investments in foreign countries. There are several limitations to the management of this risk, including:

  • Volatility of Exchange Rates: Currency exchange rates are highly volatile, which makes them difficult to predict and can add considerable uncertainty to financial projections.
  • Cost of Hedging: Hedging strategies such as forward contracts or options can help to mitigate the risks associated with currency fluctuations, but these strategies can be costly.
  • Difficulty of Forecasting: Exchange rates are determined by a variety of economic and political factors, making it difficult to accurately forecast future exchange rates.
  • Impact on Profitability: Changes in exchange rates can have a significant impact on the profitability of a business, as profits earned in foreign currencies may be reduced when converted back to the home currency.
  • Restrictions on Currency Trading: Some countries may place restrictions on the trading of foreign currencies, limiting the ability to hedge against exchange rate risk.

Other approaches related to Translation Risk

Translation Risk can be approached from various angles. In addition to foreign exchange rate risk, the following strategies can be employed to manage this type of risk:

  • Hedging - Hedging is a financial strategy used to reduce the risk of losses from volatile currency markets. Hedging involves using derivatives such as futures, options, and swaps to limit the potential losses of exchange rate fluctuations.
  • Currency Options - Currency options are contracts that give the buyer the right, but not the obligation, to buy or sell a specified currency at a predetermined exchange rate at a certain date in the future.
  • Currency Swaps - A currency swap is a contract between two parties in which one party agrees to exchange a given amount of currency with another party at a predetermined exchange rate at a certain date in the future.
  • Currency Futures - Currency futures are contracts that obligate two parties to exchange a specified amount of currency at a predetermined exchange rate at a certain date in the future.

In conclusion, there are various approaches to managing Translation Risk, including hedging, currency options, currency swaps, and currency futures. Each of these strategies has its own advantages and disadvantages, and should be considered based on the specific needs of the organization.

Footnotes

  1. ↑ A. Chernobai,, P. Jorion,, & F. Yu, 2011 pp.1-4.)
  2. ↑ A. Chernobai,, P. Jorion,, & F. Yu, 2011 pp.1-4.
  3. ↑ M. Bac,2010, pp.8-11
  4. ↑ M. Bac,2010, pp.8-11
  5. ↑ J. Shoop 2014, pp.7-9
  6. ↑ J. Shoop 2014, pp.7-9
  7. ↑ A. Chernobai,, P. Jorion,, & F. Yu, 2011 pp.1-44
  8. ↑ M. Bac,2010, p.9
  9. ↑ M. Bac,2010, p.9
  10. ↑ J. Shoop 2014, pp.11-12
  11. ↑ J. Shoop 2014, pp.11-12
  12. ↑ J. Shoop 2014, pp.11-12
  13. ↑ G.A. Holton, 2013 pp.15
  14. ↑ W. G. Njaaga 2013, pp.11-13
  15. ↑ W. G. Njaaga 2013, pp.11-13
  16. ↑ G.A. Holton,, 2013,pp.15-16
  17. ↑ W. G. Njaaga 2013, pp.11-13
  18. ↑ G.A. Holton, 2013,pp.15-16
  19. ↑ J. Bogićević, L. Dmitrović Šaponja, M.Pantelić, 2016,pp. 164-165


Translation Risk — recommended articles
Currency risk — Asset swap — Price risk — Cash is king — Variation Margin — Noncovered security — Fair value hedge — Interest rate differential — Forward points

References

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