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Source of Translation Exposure

Translation risk usually arises in the area of corporate finance.

Translation risk is normally longer-term than most transaction exposures (see below).

A translation exposure usually occurs when a company holds a financial interest in an overseas business. This could be an equity investment in another company (joint venture), or an overseas manufacturing facility, overseas subsidiary, branch, partnership or other enterprise. If these interests have a separate, local currency, balance sheet, they introduce a currency exposure on translation when consolidated with the parent company's balance sheet.

The exposure arises from the fact that any change in the translated value of such an asset (or liability), resulting from fluctuations in exchange rate movements must be recorded for accounting purposes.

The FX exposure may manifest itself in several ways:

Assets/liabilities denominated in foreign currency

Balance sheets denominated in foreign currency

Profits and losses denominated in foreign currency

Bank Currency Accounts

Translation exposure will be noticed particularly at the end of the accounting period (quarterly, half yearly, annually) when balance sheets are made up, converted to a single currency and consolidated.

This does not imply that the overseas interest is not performing well in local currency terms. In fact the better the overseas asset performs, and the greater its contribution to the parent company's overall results, the greater the impact after currency translation on the consolidated balance sheet.

Whilst there is usually no direct cash effect arising from this kind of exposure, it could have an impact on consolidated balance sheet strength, share price and borrowing capacity.

If the exchange rate of the currency in which the overseas interest's balance sheet is prepared is weak against the parent company's exchange rate, this can reduce the value of the interest's assets and profits when translated and consolidated into the parent company's balance sheet. This can reduce the value of the parent company and possibly affect its share price and ability to borrow at economic/competitive interest rates.

Moreover, 'unrealised' accounting exposures will be realised in the event of disposal of the assets in question. When conversion between currencies becomes an actuality (e.g. when an asset disposal is scheduled), a translation exposure will become a transaction exposure (see below).