In order that the company protects its financial position during the short term from the risks and issues enumerated above the following are some of the measures the company may consider adopting: Forward contracts: By entering into forward contracts relating to the foreign exchange transactions, the company would do well to protect itself from the exposures. The forward transaction may take the form of hedging. Hedging involves lower cost and provides effective insurance against the foreign exchange risks.
Price Adjustment Clauses: The Company may enter into such contracts that provide for the currency adjustment factors to prevent the losses from the changes in the exchange rates. Another variant may be tried in fixed rate contract where the acceptable foreign exchange rate is pegged to certain value so that the company is not affected by any fluctuations in the exchange rates Currency Options: “A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period of time.
” (Investopedia) This enables the company to take care of its exchange risks either by holding on to or by selling the foreign currency depending upon the fluctuations in the exchange rates. Borrowing and Lending in Foreign Currency: The company can easily cover is transaction exposure by borrowing and lending in the foreign currency only so that at any point of time it is not exposed to any foreign exchange rate fluctuations.
Invoicing in Home Currency: Invoicing in home currency, instead of in the foreign currency will reduce the transaction exposure risk for the company, since there would not be any involvement in the foreign currency for the company. Financial Directory defines the Translation exposure as the “Risk of adverse effects on a firm’s financial statements that may arise from changes in Exchange rates” Because of the investments in the foreign country ‘Ruritania’ the company is sure to acquire assets and incur various liabilities in that country. Moreover the country will derive income from the operations of that country also.
When the company wants to value these assets acquired and liabilities contracted in the foreign country, naturally an exchange rate needs to be adopted for the valuation. Because of the change in the value being adopted for the foreign currency the value of assets and liabilities may get vitiated resulting in a loss to the company. As this risk purely is the outcome of the accounting treatment to the assets and liabilities of the company, the risk may also be termed as ‘Accounting Risk’. In order to mitigate the effect of the translation risk accountants usually adopt various methods by which they safeguard the company against the risks.
Consolidation technique is one of such methods being employed by the accountants. They also use effective cost accounting evaluation procedures as a safeguard against this risk. In most of the cases the positive or negative results of such transaction is recorded as exchange rate profits or losses in the financial statements. The Translation exposure can be managed by adopting the techniques like adjusting the fund flows, entering into forward contracts and exposure netting. Economic Exposure indicates the extent to which the firm’s market value is sensitive to the unexpected changes in the foreign currency.
Long term currency fluctuations affect the value of the firms income statement, balance sheet by altering its competitive position in the country. Economic exposure depends on the unique characteristic of an industry and the individual characteristics of an individual firm. Economic exposure alter the position of the firms standing by affecting its sales value, cost of goods sold, operating profits, market share, share prices and the market value of the firm as such. Analysts use the Foreign Exchange Beta to calculate a firm’s economic exposure.
“It is the most subtle and insidious of all the types of exposure, and has the potential to ruin a company, but to do it in a very surreptitious manner” (Lecture 6) Economic exposure arises when it is expected that future cash flows will be affected by a change in the exchange rates. Economic exposure is thus the extent to which the present value of the future cash flows are affected by the movements in the foreign exchange rates. Even the changes in the value of the competitors’ currencies may have effect on the company’s market share and sales growth when the company is dealing globally.