Foreign Exchange Risk and International Business Finance Essay

The first things come to the mind when we read the word foreign exchange is, it must be related to international business. And in a way it is true. When companies or individuals get themselves into such activity that involves cash flow in different currencies, the value relationship between those currencies becomes important. This relation is known as foreign exchange rate.

The purchase and financing of assets m another currency A classic example (mentioned m both Smithson (1998) and Campbell and Krakaw (1993)) revolves the now-defunct Laker Alrhnes In the late 1970s, the U S dollar was weak relative to the British pound, and thus there was significant demand among the British for vacations in the U S In response to this demand, Laker Airline purchased several additional planes, financing them m U S dollars When, m the next few years, the dollar strengthened relative to the pound, Laker Airline had a double problem

1.  Its revenues were in pounds and its debt largely in dollars (a mismatch which, because of the strengthened dollar, affected the company adversely), and
2. The demand for U S vacations among the British fell (due to the no longer favorable exchange rate) The first problem resulted from a transaction exposure, the second resulted from an operating exposure Laker Airlines went bankrupt in 1982.

Translation exposure an accounting-based exposure resulting from a company has to convert asset and/or hardly ~terms from one currency to another for financial statement purposes.

This can occur, for example, when a U K parent company must restate the (foreign-denominated) assets and liabilities of a foreign subsidiary in U S dollars for the Parent's financial statements. The degree of this risk depends upon the specific accounting rules pertaining to the exchange rate movements and the financial ~terms involved.

Operating exposure an exposure associated with the potential impact of changes in exchange rates on the future cash flows of the company. This can also be referred to as economics exposure, since the economic value of a company's a function of the firm's future cash flows the above-mentioned second problem experienced by Laker Airlines - the change m demand for vacations and the resulting diminished revenue stream due to the strengthened dollar's an example of this type of exposure.

(Ref: https://ideas.repec.org/p/imf/imfwpa/06-255.html )

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