What is Translation Exposure?

Translation exposure is the risk of having changes in foreign exchange rates trigger losses on business transactions or balance sheet holdings. These losses can occur when a firm has assets, liabilities, equity, or revenue denominated in a foreign currency and needs to translate them back into its home currency. Translation is required by the accounting standards when preparing consolidated financial statements.

What Causes Translation Exposure?

Translation exposure is most common in two situations. One is when a company has subsidiaries located in other countries, and the other is when a business engages in significant sales transactions in other countries. In both cases, there is a risk that an unfavorable change in the applicable exchange rates could cause a loss on the books of the reporting entity. These businesses can engage in hedging transactions to reduce their translation exposure.

How to Hedge Translation Exposure

There are several methods available for hedging translation exposure. One approach is for the business to require its customers to pay it in the entity’s home currency. This means that the firm never deals with foreign currency, and instead forces its customers to taken on this risk. This approach is possible, but only if the seller has so much market power that it can force its customers to take on the translation exposure. Another option is for the seller to enter into a currency swap contract, where it pays a fee to acquire or sell the necessary currency at a fixed exchange rate on a future date.