Define transaction risk, translation risk and economic risk and compare them with one another.
The idea
Currency risk takes three forms. Transaction risk is the effect of exchange rate changes on the home-currency value of contractual foreign-currency cash flows, such as receivables, payables and foreign-currency debt. It ends in a realised cash gain or loss. Translation risk is the accounting effect of restating foreign subsidiaries' financial statements into the parent's reporting currency, so it changes reported values without any direct cash flow. Economic risk, also called operating risk, is the effect of lasting exchange rate changes on the present value of a firm's future operating cash flows and competitive position, including cash flows that are not yet contracted. The key distinctions are the time horizon, whether a cash flow is contracted and whether cash actually moves. A firm that invoices everything in its home currency has no transaction risk but can still have economic risk.
A practice question
Transaction risk is best described as the risk that:
- the consolidated financial statements show lower values when a foreign subsidiary's accounts are converted into the reporting currencyWhy not: That is translation risk, an accounting effect.
- a firm's long-run competitive position and future operating cash flows change as exchange rates moveWhy not: That describes economic risk, which is about future operating cash flows, not contracted flows.
- a counterparty fails to deliver its leg of a foreign exchange tradeWhy not: That is settlement or credit risk, not exchange rate risk.
- a contracted foreign-currency cash flow, such as a receivable, changes in home-currency value before settlement - correct
Transaction risk attaches to contractual foreign-currency cash flows already committed, such as receivables, payables and foreign-currency debt. The loss or gain is realized when the cash flow is converted.
A harder one
A US firm faces three situations: (i) a EUR 4 million receivable due in 60 days; (ii) the year-end conversion of its German subsidiary's equity into USD for the consolidated balance sheet; (iii) a Japanese competitor that sells at lower USD prices after the yen weakens, eroding the firm's export sales over several years. Which classification is correct, in order (i), (ii), (iii)?
- Translation risk, transaction risk, economic riskWhy not: Swaps (i) and (ii); a receivable is a contractual cash flow (transaction risk), not an accounting restatement.
- Transaction risk, translation risk, economic risk - correct
- Economic risk, translation risk, transaction riskWhy not: Swaps (i) and (iii); the lasting loss of competitiveness is economic risk, the contractual receivable is transaction risk.
- Transaction risk, economic risk, translation riskWhy not: Swaps (ii) and (iii); restating a subsidiary's equity is translation risk, not an operating effect.
A fixed foreign-currency receivable is transaction risk. Restating a subsidiary's accounts at year-end is translation risk. A long-lasting change in competitive position is economic risk.
The hardest tier
A US parent has a UK subsidiary with net assets of GBP 40 million and itself holds a GBP 10 million receivable due in 30 days. GBP/USD falls from 1.2650 to 1.2300. Which pair correctly gives the translation loss on the net assets and the transaction loss on the receivable?
- Translation loss USD 0.35 million; transaction loss USD 1.40 millionWhy not: Swaps the two: the translation effect applies to the GBP 40 million of net assets, the transaction effect to the GBP 10 million receivable.
- Translation loss USD 1.75 million; transaction loss zeroWhy not: Lumps the receivable in with the net assets; the receivable is a contractual cash flow and gives a transaction loss.
- Translation loss USD 1.40 million; transaction loss zeroWhy not: Ignores the GBP receivable, which loses value in USD terms and is a transaction exposure.
- Translation loss USD 1.40 million; transaction loss USD 0.35 million - correct
Fall in GBP/USD = 0.0350. Translation loss = 40m x 0.0350 = USD 1.40 million (accounting). Transaction loss = 10m x 0.0350 = USD 0.35 million (realized when the receivable is collected).
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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