Foreign exchange PROTECTION MEASURES:
1. Transaction Exposure (TE):
- It occurs when a value of a future transaction, through known with certainty, is denominated in some currency other than the domestic currency.
- In such cases, the monetary value is fixed in terms of foreign currency at the time of agreement, which is complete at a later date.
- EX: an Indian exporter is to receive payment in euros in 90 days time for an export made today. His receipt in euros is fixed and certain but as far as the re. Value is concerned; it is uncertain and will depend upon the exchange rate prevailing at the time of receipt.
- All fixed money value transactions such as receivables; payables, fixed price sale and purchase contracts etc. are subject to transaction exposure.
- TE refers to the potential change in the value of a foreign currency denominated transaction due to changes in the exchange rate.
- It covers rate risk, credit risk and liquidity risk.
- This is also called the accounting exposure
- It refers to and deals with the probability that the firm may suffer a decrease in assets value due to devaluation of a foreign currency even if no foreign exchange transaction has occurred during the year.
- This exposure needs to be measured so that the financial statement i.e. the balance sheet and the income statement reflect the change in value of assets and liabilities.
- This occurs when the firm’s foreign balances are expressed in terms of the domestic currency.
- Two related decisions involved in translation exposure management:
(a) Managing balance sheet items to minimize the net exposure
(b) Deciding how to hedge against this exposure
- It results in exchange rate losses and gains that are reflected in the firm’s accounting record and are not realized and hence have no impact on the taxable income.
2. Economic Exposure:
- It refers to the probability that the change in foreign exchange rate will affect the value of the firm.
- The risk contained in economic exposure requires a determination of the effect of changes in exchange rates on each of the expected future cash flows.
- The translation and the transaction losses are one-time events, whereas the economic loss is a continuous one.