Foreign Currency Risk

XYZ Foreign Currency Risks

Student’s Name

Institutional Affiliation

XYZ Foreign Currency Risks

Introduction

Entry into foreign territories for businesses is marred with a high number of risks all emanating from the currencies in which the country of origin and that in which the company enters. For XYZ, the company’s entry into a foreign market exposes it to a wide range of risks that threaten its operations and existence. The risk exposures include those related to transactions, operations and accounting. As a means of dealing with these risks, hedging is considered an option to help XYZ in handling the foreign currency risks. In implementing approaches to reduce the risks, accounting assumptions may feature with the differences between handling the currency risks in reporting on the basis of GAAP and IFRS also becoming necessary for XYZ to factor into its plans as detailed in the following report.

Transaction Exposures

Also known as transaction risks, occur as a result of the prevailing fluctuations of the exchange rates between the currencies used by the company in their domestic and foreign countries. Transaction exposure is considered to affect the value of the assets of the company on the market and the outstanding obligations that the company have in the market. XYZ does not have to actively engage in sales and purchases in the foreign environment but will still face transaction exposures due to the decision to engage in a foreign market. The transaction exposures are also revealed to affect the ultimate value of the firm with the accounting exposures they result on the company as further assessed in the following section.

Accounting Exposures

Foreign currency exposures or risk are also known as balance sheet exposures. The risks of accounting exposures include those having an effect on the capital structure of the company or its income statements. According to Al-Shboul and Alison (2008), the translation exposures affecting a company lead to adjustments occurring in the income statements and the balance sheets leading to an affected capital structure. Also, the adjustments emanating from translation exposures also results in changes in shareholder equities with a possible increase in the values or decrease dependent on the effect suffered by the currency in which the company presents its reports. Due to the above accounting exposures, the value of the firm is also affected by their occurrences leading to an affected position of the company either positively or negatively. Therefore, investment in a foreign country will expose XYZ to accounting exposures leading to an affected firm value.

Operating Exposures

Foreign currency exposures also include the operating exposures that a company faces running its operations in the foreign land. Operating exposures relate with accounting exposures as they both have an impact on the financial statements reported by the company in its foreign and domestic currencies. According to McCarthy (2016), changes in exchange rates have the ability to impact the cash flows of the organization affecting the operations. The effect on cash flows may occur as an anticipated attribute or contractual in nature indicating to the possible role that exchange rate changes have on the operations of a company. The difference between the two accounting and translation exposures is that operating exposures may impose an effect on the cash flows of an organization even if its operations are not in foreign currencies. An indirect impact is occasioned due to the competition prevailing in the market leading to an affected financial position and value of the firm. The introduction of the operations of XYZ in a foreign country will therefore attract also the operating risks in addition to the transaction and accounting risks. The CEO needs to factor in avenues of reducing the impact that each of the above risks will have on the organization.

Hedges on Foreign Exchange Risks

Hedging features as the main approach relied on in reducing the foreign currency risk exposures that companies in foreign territories employ. Hedging is however, divided into many forms with this report presenting forward contracts and futures as the ideal approaches applicable in reducing the risk exposures of XYZ to foreign currency.

Futures: A hedging instrument entered into by XYZ allowing the company to acquire assets, or make transactions at a specific price in future is referred to as futures. Futures may include assets of financial nature including stocks, bonds, and currencies that enable the company to shield itself from the foreign currency risks that impose operational, transaction and accounting exposures to it.

Forward Contracts: On the other hand, forward contracts also feature as ideal contributors to reducing foreign exchange risks. Forward contracts are known to help in dealing with transaction costs allowing the company to cover itself from the future fluctuations in currencies by signing contracts that help it reduce any possible transaction exposures that may occur in terms of costs. Future contracts present the ideal option to help XYZ deal with its transaction exposures given the difficulties of preventing them from imposing a risk on the company.

Accounting Assumptions

The first assumption made on this is that the company’s current approaches in accounting yield to exposures not only to accounting risks emanating from foreign currency but also those associated with the operations of the company. Also assumed in this study is that the operations of XYZ will expose it to operational risks that increasingly affect the financial reporting of the company imposing limitations to the indication of the value of the company in the foreign market. The risk exposures are also considered to have a net monetary value to the company and an effect on the liabilities the company suffers and hence the need to account for them. Applying the temporal method of translation will help in minimizing the balance sheet exposures and enhance reporting for the company. The temporal method is considered ideal under GAAP which is an American based standard system used in financial reporting. Under this method, the liabilities and assets of the company are translated in value on the basis of the current rates prevailing. Under the IFRS, the current rate method is implemented. Under this accounting standard, the gain or loss emanating from translation is not included in the income statement when assessing incomes and losses for the fiscal year. A consolidated equity account is used in assessing the incomes and losses instead hence providing a difference from the approach embraced by the GAAP.

Conclusion

Evidently, XYZ is bound to face significant challenges in its quest to attain its objectives in the foreign market. Some of the risks it stands to face include the translation exposures, operation exposures and accounting exposures. However, the application of hedging with options such as futures and forward contracts will help the organization deal with the above risks reducing the impact that these may have on the financial reporting of the company and its value.

References

Al-Shboul, M., & Alison, S. (2008). Translation Exposure and Firm Value, Evidence from Australian Multinational Corporations. International Review of Business Research Papers, 4(1), 23-44.

McCarthy, S. (2016). Foreign Exchange Operating Exposure: A Practical Teaching Approach. Journal of Financial Education, 42(1-2), 116-136.