Companies are exposed to three types of risk caused by currency volatility −
● Transaction exposure − Exchange rate fluctuations have an effect on a company’s obligations to make or receive payments denominated in foreign currency in future. Transaction exposure arises from this effect and it is short-term to medium-term in nature.
● Translation exposure − Currency fluctuations have an effect on a company’s consolidated financial statements, particularly when it has foreign subsidiaries. Translation exposure arises due to this effect. It is medium-term to long-term in nature.
● Economic (or operating) exposure − Economic exposure arises due to the effect of unpredicted currency rate fluctuations on the company’s future cash flows and market value. Unanticipated exchange rate fluctuations can have a huge effect on a company’s competitive position.
Note that economic exposure is impossible to predict, while transaction and translation exposure can be estimated.