Analyse the difference between translation and transaction exposure. Use examples to demonstrate your understanding.
Translation exposure is also known as translation risk and is the risk that value of a company’s assets and liabilities will change due to exchange rate changes. Translation exposure comes into picture when a part of a company’s assets and liabilities and its income are denominated in a foreign currency. This type of exposure is also called accounting exposure.
Transaction exposure arises when a business transaction is based in a foreign currency and the value of that currency faces the possibility of changing before the transaction is complete. In other words we can say that translation exposure impacts the valuation of assets and liabilities while transaction exposure impacts forex transaction’s cash flow.
Let me explain by giving examples. Toyota Motors is Japanese Company that makes and sells popular cars like Corolla, Camry etc. The company has subsidiaries in different countries. Suppose that Toyota is consolidating the financials of its foreign subsidiary in USA then any change in the company’s value of assets and liabilities in USA due to exchange rate movements of JPY (Japanese Yen) and USD (US Dollars) will have to be recorded in books as a book gain or loss. Now suppose that Toyota only has operations in Japan. It buys certain raw materials from USA and due to exchange rate movements of JPY (Japanese Yen) and USD (US Dollars) the cost of these raw materials has now increased for Toyota. This increase in cost of raw materials is an example of transaction exposure.
Analyse the difference between translation and transaction exposure. Use examples to demonstrate your understanding.
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