19.2 Transaction, Translation, and Economic Exposure

Transaction Exposure

Transaction exposure is the risk that the value of a business’s expected receipts or expenses will change as a result of a change in currency exchange rates. It is short-term to medium-term in nature (International Finance Tutorial, n.d.).

In reference to the example discussed in Chapter 18.1 Exchange Rates, if Starbucks agrees to pay a Brazilian coffee grower seven million Brazilian reals for an order of one million pounds of coffee beans, Starbucks will need to purchase Brazilian reals to pay the bill. How much it will cost Starbucks to purchase these Brazilian reals depends on the exchange rate at the time Starbucks makes the purchase. For instance, in March 2021, with an exchange rate of [latex]\text{USD}0.1839 = \text{BRL}1[/latex], it would have cost Starbucks [latex]$0.1839 × 7,000,000 = $1,287,300[/latex] to purchase the reals needed to receive the one million pounds of coffee beans.

If, however, Starbucks agreed in March to purchase the coffee beans several months later, in July, Starbucks would not have known then what the exchange rate would be when it came time to complete the transaction. Although Starbucks would have locked in a price of [latex]\text{BRL}7,000,000[/latex] for one million pounds of coffee beans, it would not have known what the coffee beans would cost the company in terms of U.S. dollars.

If the US dollar appreciated so that it cost less to purchase each Brazilian real in July, Starbucks would find that it was paying less than [latex]$1,287,300[/latex] for the coffee beans. For example, suppose the dollar appreciated so that the exchange rate was [latex]\text{USD}0.1800 = \text{BRL}1[/latex] in July 2021.

Then the coffee beans would only cost Starbucks [latex]$0.1800 × 7,000,000=$1,260,000[/latex].

On the other hand, if the US dollar depreciated and it cost more to purchase each Brazilian real, then Starbucks would find that its dollar cost for the coffee beans was higher than it expected. If the US dollar depreciated (and the Brazilian real appreciated) so that the exchange rate was [latex]\text{USD}0.200 = \text{BRL}1[/latex] in July 2021, then the coffee beans would cost Starbucks [latex]$0.2000 × 7,000,000 = $1,400,000[/latex]. This uncertainty regarding the dollar cost of the coffee beans Starbucks would purchase to make its lattes is an example of transaction exposure.

A global company such as Starbucks has transaction exposure not only because it is purchasing raw materials in foreign countries but also because it is selling its product and thus collecting revenue in foreign countries too. Customers in Japan, for example, spend Japanese yen when they purchase a Starbucks cappuccino, coffee mug, or bag of coffee beans. Starbucks must then convert these Japanese yen to US dollars to pay the expenses that it incurs in the United States to produce and distribute these products.

If a company is receiving yen from customers and paying expenses in dollars, the company is harmed when the yen depreciates relative to the dollar, meaning that the yen the company receives from its customers can be exchanged for fewer dollars. Conversely, when the yen appreciates, it takes fewer yen to purchase each dollar, this appreciation of the yen benefits companies with revenues in yen and expenses in dollars.

Translation Exposure

In addition to the transaction risk, if Starbucks holds assets in a foreign country, it faces translation exposure. Thus, translation exposure  is the impact currency fluctuations have on company’s consolidated statements when it has foreign subsidiaries. Translation risk is an accounting risk and is medium term to long-term in nature (International Finance Tutorial, n.d.).

Starbucks, for instance, might purchase a coffee plantation in Costa Rica for 120 million Costa Rican colones. This land is an asset for Starbucks, and as such, the value of it should appear on the company’s balance sheet. The balance sheet for Starbucks is created using US dollar values. Thus, the value of the coffee plantation has to be translated to dollars. Because exchange rates are volatile, the dollar value of the asset will vary depending on the day on which the translation takes place. If the exchange rate is 500 colones to the dollar, then this coffee plantation is an asset with a value of $240,000[latex][/latex]. If the Costa Rican colón depreciates to 600 colones to the dollar, then the asset has a value of only $200,000 when translated using this exchange rate.

Although it is the same piece of land with the same productive capacity, the value of the asset, as reported on the balance sheet, falls as the Costa Rican colón depreciates. This decrease in the value of the company’s assets must be offset by a decrease in the stockholders’ equity for the balance sheet to balance. The loss is due simply to changes in exchange rates and not the underlying profitability of the company.

Economic/Operating Exposure

Economic exposure is the most important risk out of the three. It arises due to the impact currency fluctuations have on company’s cash flows. Economic exposure is long-term and has adverse effects on company’s market value (Borad, 2022).

Even a company that is not involved in international transactions can face this type of risk. Consider a company located in Mississippi that makes shirts using 100% U.S.-grown cotton. All of the shirts are made in the United States and sold to retail outlets in the United States. Thus, all of the company’s expenses and revenues are in US dollars, and the company holds no assets outside of the United States.

Although this firm has no financial transactions involving international currency, it can be impacted by changes in exchange rates. Suppose the US dollar strengthens relative to the Vietnamese dong. This will allow U.S. retail outlets to purchase more Vietnamese dong, and thus more shirts from Vietnamese suppliers, for the same amount of US dollars. Because of this, the retail outlets experience a drop in the cost of procuring the Vietnamese shirts relative to the shirts produced by the firm in Mississippi. The Mississippi company will lose some of its customers to these Vietnamese producers simply because of a change in the exchange rate.

References

Borad, S.B. (2022). Economic exposure. eFinanceManagement. https://efinancemanagement.com/international-financial-management/economic-exposure

International Finance Tutorial. (n.d.). Tutorials Point. https://www.tutorialspoint.com/international_finance/index.htm

Attribution

"Chapter 19: Exchange Rate Risk Management" is an adaptation of "20.3 Exchange Rates and Risk" from Principles of Finance by Julie Dahlquist & Rainford Knight, published by OpenStax - Rice University and licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted. Access “Principles of Finance” for free.