MNEs’ financial strategy is to protect against the foreign-exchange risk (or exposure) of investing abroad. Strategies to protect against such risks include the internal movement of funds, and the use of foreign-exchange instruments such as options and forward contracts.
A. Types of Exposure
There are three types of foreign-exchange exposure:
1. Translation Exposure: It is the foreign-exchange risk that occurs because a parent firm must
translate foreign-currency financial statements into the reporting currency of the parent, i.e., the
value of the exposed asset/liability changes as the exchange rate varies.
2. Transaction Exposure: It is the foreign-exchange risk that arises because a firm has
outstanding accounts receivable or payable that are denominated in a foreign currency, i.e., the
receivable or payable changes in value as the relevant exchange rate changes.
3. Economic Exposure: It is the foreign-exchange risk that arises from effects of exchange-rate
changes on future cash flows, the sourcing of parts and components, the location of
investments, and the competitive position of the company in different markets.
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