A common definition of exchange rate risk relates to the effect of unexpected exchange rate changes on the value of the firm (Madura, 1989). In particular, it is defined as the possible direct loss (as a result of an unhedged exposure) or indirect loss in the firm’s cash flows, assets and liabilities, net profit and, in turn, its stock market value from an exchange rate move. To manage the exchange rate risk inherent in multinational firms’ operations, a firm needs to determine the specific type of current risk exposure, the hedging strategy and the available instruments to deal with these currency risks.
Multinational firms are participants in currency markets by virtue of their international operations. To measure the impact of exchange rate movements on a firm that is engaged in foreign-currency denominated transactions, i.e., the implied value-at-risk (VaR) from exchange rate moves, we need to identify the type of risks that the firm is exposed to and the amount of risk encountered (Hakala and Wystup, 2002). The three main types of exchange rate risk that we consider in this paper are (Shapiro, 1996; Madura, 1989):
1. Transaction risk, which is basically cash flow risk and deals with the effect of
exchange rate moves on transactional account exposure related to receivables (export
contracts), payables (import contracts) or repatriation of dividends. An exchange rate change in the currency of denomination of any such contract will result in a direct transaction exchange rate risk to the firm;
2. Translation risk, which is basically balance sheet exchange rate risk and relates
exchange rate moves to the valuation of a foreign subsidiary and, in turn, to the consolidationof a foreign subsidiary to the parent company’s balance sheet. Translation risk for a foreign subsidiary is usually measured by the exposure of net assets (assets less liabilities) to potential exchange rate moves. In consolidating financial statements, the translation could be done either at the end-of-the-period exchange rate or at the average exchange rate of the period, depending on the accounting regulations affecting the parent company. Thus, while income statements are usually translated at the average exchange rate over the period, balance sheet exposures of foreign subsidiaries are often translated at the prevailing current exchange rate at the time of consolidation; and
3. Economic risk, which reflects basically the risk to the firm’s present value of
future operating cash flows from exchange rate movements. In essence, economic risk
concerns the effect of exchange rate changes on revenues (domestic sales and exports) and operating expenses (cost of domestic inputs and imports).Economic risk is usually applied tothe present value of future cash flow operations of a firm’s parent company and foreign subsidiaries. Identification of the various types of currency risk