If the US$ weakens, only the net US$1m becomes less valuable. The holding company’s investment is only US$1m and the company’s net assets in US$ are only US$1m. Its statement of financial position would look something like this: For example, take a US subsidiary that has been set up by its holding company providing equity finance. It can be partially overcome by funding the foreign subsidiary using a foreign loan. However, the term ‘translation risk’ is usually reserved for consolidation effects. It also becomes important if the subsidiary pays dividends. However, it would be important if the holding company wanted to sell the subsidiary and remit the proceeds. Usually, this effect is of little real importance to the holding company because it does not affect its day-to-day cash flows. If the subsidiary is in a country whose currency weakens, the subsidiary’s assets will be less valuable in the consolidated accounts. This affects companies with foreign subsidiaries. Although raw materials might still be imported and affected by exchange rates, other expenses (such as wages) are in the local currency and not subject to exchange rate movements. Make your goods in the country you sell them.Trade from the US to the UK would not have been so badly affected. If, in the same period, the £/US$ exchange rate moved from £/US$0.6263 to £/US$0.6783, a strengthening of the US$ relative to £ of only about 8%. This made it less competitive for US manufacturers to export to a eurozone country. This meant that the € had weakened relative to the US$ (or the US$ strengthened relative to the €) by 19%. For example, over the six months 14 January 2010 to 14 June 2010 the €/US$ exchange rate moved from about €/US$0.6867 to €/US$ 0.8164. Try to export or import from more than one currency zone and hope that the zones don’t all move together, or if they do, at least to the same extent.In general, the following approaches might provide some help: If competing imports could become cheaper you are suffering risk arising from currency rate movements.ĭoing something to mitigate economic risk can be difficult – especially for small companies with limited international dealings. Note that a company can, therefore, experience economic risk even if it has no overt dealings with overseas countries. Similarly, goods imported from Europe will be cheaper in sterling than they had been, so those goods will have become more competitive in the UK market. So goods where the UK price is £100 will cost €130 instead of €110, making those goods less competitive in the European market. For example, if a company is exporting (let’s say from the UK to a eurozone country) and the euro weakens from say €/£1.1 to €/£1.3 (getting more euros per pound sterling implies that the euro is less valuable, so weaker) any exports from the UK will be more expensive when priced in euros. The source of economic risk is the change in the competitive strength of imports and exports. There are three main types of currency risk as detailed below.Įconomic risk. Increasingly, many businesses have dealings in foreign currencies and, unless exchange rates are fixed with respect to one another, this introduces risk. This article has been updated to reflect the knowledge of basis risk that students are expected to have for Financial Management. An introduction to professional insights.Virtual classroom support for learning partners.Becoming an ACCA Approved Learning Partner.
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