Foreign exchange exposure can occur due to unanticipated currency fluctuations. There are three types of foreign exchange exposure: 1) Translation exposure emerges when consolidating financial statements across currencies. It does not affect cash flow. 2) Transaction exposure affects current cash flows from imports/exports and foreign loans/investments. 3) Real operating exposure impacts future cash flows depending on factors like exchange rates, inflation rates, import/export levels, and demand elasticity. Measuring real operating exposure involves estimating cash flows under different currency scenarios and discounting to present value.

1. Foreign Exchange Exposure
• Foreign Exchange exposure occurs because
of unanticipated change in the exchange
rate. In a floating exchange rate regime, the
value of a currency changes frequently
causing change in value of assets, liabilities
and cash flows of firms involved in
international transactions.

2. Types of Foreign Exchange
Exposure
• 1. Translation or Accounting Exposure
• 2. Economic Exposure

3. Translation or Accounting
Exposure
• This emerges on account of
consolidation of the
financial statements of different units of a
multinational firm. It does not affect the
cash flow.

4. Economic Exposure
Economic exposure is the result
of the altered cash flow of a firm.

5. Economic exposure is further
classified into two-
• Transaction Exposure- related with the
changes in the present cash flows.
• Real Operating Exposure- related to the
changes in future cash flows.

6. Transaction Exposure
• Transaction Exposure emerges mainly on
account of export and import of
commodities*, borrowing and lending in a
foreign currency and intra firm flows in an
international company

7. *The transaction exposure on account of
trade is divided into three parts:
• Quotation exposure – created when exporter
quotes a price in foreign currency and exists till
the importer places an order.
• Backlog exposure – Exists between the placement
of order by importer and the shipping and billing
by the seller.
• Billing exposure – Exists between the billing of
shipment and the settlement of the trade payments.

8. Transaction exposure of a multinational
firm is always considered in terms of
consolidated net exposure.

9. Real Operating Exposure
Arises when changes in exchange rate,
together with rates of inflation, alter the
amount and risk element of a company’s
future revenue and cost stream. The word
real denotes the real exchange rate which
means nominal exchange rate adjusted for
inflation.

10. • The word, “operating” is used because we
are concerned with the operating cash flow,
a change in which causes change in the
value of the firm.
• The impact of inflation and changes in
exchange rate on the future cash flow may
vary under different market conditions.

11. As far as revenue is concerned, the
impact may vary if the firm produces:
• for the foreign market
• for the domestic market but competition
from import is present
• for the domestic market and there is no
competition from import.

12. The impact on the cost structure will be
different if the firm
• imports inputs
• procures inputs from domestic sources, but
competition from foreign supplier is present
• procures inputs from domestic sources and
there is no competition from foreign
suppliers

13. Measuring the impact on cash flow
• For a precise estimate of the real operating
exposure, one has to take into consideration
the expected inflation rate differential, the
expected change in the exchange rate, the
price elasticity of demand for the output, the
ratio of imported input in the total input etc.
There will be many combinations of these
factors and in each combination, the amount
of cash flow will be different.

14. • When cash flow of different combinations over
the years is estimated, it is converted to present
value and this is compared with the present value
of the cash flow that is expected to occur in the
case of a stable real exchange rate. The difference
between the two is the real operating exposure.

15. Example:
• We suppose there are only two scenarios in
currency depreciation. First scenario – the firm
produces only for foreign market and the demand
is price inelastic in which case sale will not move
up and since the imported inputs will be costlier,
the net cash inflow would be negative. Second
scenario – sale expands both in the local market
and foreign market, substitutes for imported inputs
are available in domestic market and so the cost
does not rise.

16. Period Scenario I Scenario II
Year I Rs. –4500 Rs. 8000
Year II Rs. –5000 Rs. 7000
Year III Rs. –6000 Rs. 6500

17. Present values if discount rate is 10%
• Scenario I:
• -4500/1.10 + (-5000)/(1.10)2
+ (-6000)/
(1.10)3
= Rs. –12,731
Scenario II:
8000/1.10 + 7000/(1.10)2
+ 6500/(1.10)3
= Rs. 17, 942

18. If we suppose there is no change in real
exchange rate, the cash flow over the 3 year
period is Rs. 10,000.
Then, real operating exposure in
Scenario I = Rs. 22,731
Scenario II = Rs. 7,942

19. In case of MNCs, the operating cash flow
is governed not only by inter-firm
transactions but also intra-firm
transactions. Moreover, a large number of
currencies are involved, where some may
depreciate and others appreciate. So it is
the net effect that determines the size of
real operating exposure.

20. Translation Exposure
Emerges on account of consolidation of financial
statements of different units of a multinational
firm. Consolidation is done through translating the
items of the financial statements of subsidiaries
denominated in different currencies into the
domestic currency of the parent company. When
the currency of any of the host countries changes
its value, its translated value in the domestic
currency of the parent company changes as does
the picture of the consolidated statement. The
extent of this change represents the magnitude of
translation exposure.

21. If the subsidiary maintains its account in the
reporting currency i.e. the domestic
currency of the parent company as is
sometimes done by the extended
departments of a firm abroad, the
translation exposure does not emerge.