Manag., December-2019 – Q28
- Option :
- Explanation : An asset denominated or valued in terms of
foreign-currency cash flows will lose value if
that foreign currency declines in value. It can
be said that such an asset is exposed to
exchange rate risk. However, this possible
the decline in asset value may be offset by the
the decline in value of any liability that is also
denominated or valued in terms of that foreign
currency. Thus, a firm would normally be
interested in its net exposed position (exposed assets—exposed liabilities) for each period
in each currency.
Although expected changes in exchange rates can often be included in the cost-benefit analysis relating to such transactions, in most cases, there is an unexpected component in exchange rate changes and often the cost-benefit analysis for such transactions does not fully capture even the expected change in the exchange rate. For example, price increases for the foreign operations of many MNCs often have to be less than those necessary to fully offset the exchange rate changes, owing to the competitive pressures generated by local businesses.
Three measures of foreign exchange exposure are translation exposure, transaction exposure, and economic exposure. Translation exposure arises because the foreign operations of MNCs have accounting statements denominated in the local currency of the country in which the operation is located. For U.S. MNCs, the reporting currency for its consolidated financial statements are the dollar, so the assets, liabilities, revenues, and expenses of the foreign operations must be translated into dollars. International transactions often require a payment to be made or received in foreign currency in the future, so these transactions are exposed to exchange rate risk. Economic exposure exists over the long term because the value of future cash flows in the reporting currency (that is, the dollar) from foreign operations is exposed to exchange rate risk. Indeed, the whole stream of future cash flows is exposed.
