The growth of international trade has led to increased exposure to currency risk for many companies. Managing the exchange rate results in three main types of risks, including transaction, economic, and translation risk. Many companies manage their exchange rate risk by hedging it using complex financial instruments. Said hedging consists of reducing the uncertainty related to the cash flows derived from positive exchange risk. One way to hedge exchange rate risk is to buy or sell currencies at a predetermined future date and price.
The transaction risk component of exchange rates is also known as a short-term economic risk. This is related to the risk of the specific contracts in which the company has already entered which results in currency risks. A business may have to incur risk on either the buy or sell side of a business transaction. Any of these that give rise to an entry or exit of a foreign currency produces said risk. For example, Company A located in the United States has a contract to purchase raw material from Company B located in the United Kingdom for the next two years at a product price set today. In this case, company A is the foreign exchange payer and is exposed to transaction risk from movements in the rate of the British pound against the dollar. If it depreciates, company A has to make a smaller payment in dollar terms, but if the pound appreciates, company A has to pay a larger amount in dollar terms, with the consequent risk in foreign currency
The economic risk
Rather, economic risk is a long-term effect of transaction risk. If a company is continually affected by unavoidable long-term currency risk, it is said to have economic risk. This results in an impact on the market value of the company since the risk is inherent to the company and affects its profitability over the years. A brewer in Argentina, which has its concentration in the United States market, is continuously exposed to movements in the price of the dollar and is said to have an economic currency risk.
The risk of foreign currency translation is of an accounting nature and relates to the gain or loss arising from the translation or transfer of the financial statements of a subsidiary located in another country. A company like General Motors could sell cars in about 200 countries and make them in up to 50 different countries. This company has subsidiaries or operations abroad and is exposed to the risk of transfer. At the end of the fiscal year, the company is obliged to report all its combined operations in terms of the national currency that lead to a profit or loss resulting from the movement in different foreign currencies.