## **Learning Outcomes**

After reading this article, you will be able to identify and explain the main types of currency risk: transaction, translation, and economic risk. You will understand how each risk arises, recognise their impact on businesses trading internationally, and describe the hedging techniques used to manage these exposures. This knowledge is essential for answering currency risk and hedging questions in the ACCA Financial Management (FM) exam.

## **ACCA Financial Management (FM) Syllabus**

For ACCA Financial Management (FM), you are required to understand the nature of currency risk and the techniques used to manage it. In particular, you should focus your revision on the following areas:

- The three principal types of foreign currency risk: transaction, translation, and economic risk
- How exchange rate movements affect business performance and financial reporting
- Identifying and evaluating the risks present in typical international trade transactions
- Practical hedging strategies to manage foreign exchange risk, including traditional and derivative-based techniques

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which type of currency risk arises from outstanding foreign currency receivables or payables due to be settled in the future?
2. What is meant by translation risk in the context of consolidated financial statements?
3. True or false? Economic risk concerns the long-term effect of exchange rate changes on a company’s market value and competitiveness.
4. Briefly explain how a forward foreign exchange contract can be used to hedge transaction risk.
5. Give one advantage and one limitation of using options as a hedge against currency risk.

## **Introduction**

International operations expose companies to currency risk—the possibility that changes in exchange rates will affect business outcomes. For financial managers, identifying these risks and knowing how to manage them is critical to protecting profits and shareholder value.

This article covers the three main types of currency risk you need to assess for the ACCA FM exam: **transaction risk**, **translation risk**, and **economic risk**. For each, you will learn how the risk arises, its effect on financial performance, and the main hedging methods used to manage exposure.

> **Key Term: currency risk**
> The risk that changes in exchange rates will negatively impact a company's financial results or position.

## **Types of Currency Risk**

Currency risk is divided into three main categories, each with different impacts and management approaches.

### Transaction Risk

Transaction risk arises when a company has receivables or payables denominated in a foreign currency, and the settlement date is in the future. Fluctuations in exchange rates between the contract date and the settlement date can cause gains or losses when amounts are eventually converted into the home currency.

> **Key Term: transaction risk**
> The risk of exchange rate movements affecting the value of outstanding foreign currency receivables or payables before settlement.

### Translation Risk

Translation risk affects companies with subsidiaries or assets located overseas. When preparing consolidated financial statements, the results and net assets of foreign operations need to be converted into the parent company’s currency. Changes in exchange rates between reporting dates can create volatility in reported profits and balance sheet values.

> **Key Term: translation risk**
> The risk that exchange rate changes will alter the reported value of foreign operations in group accounts, without affecting actual cash flows.

### Economic Risk

Economic risk is broader and longer term. It represents the risk that exchange rate movements will undermine a company's competitive position and the present value of its future cash flows. This can happen if a stronger home currency makes exports less competitive or if a competitor benefits from a weaker currency.

> **Key Term: economic risk**
> The risk that long-term changes in exchange rates will affect a company's market value by impacting future cash flows and competitiveness.

## **Identifying and Assessing Currency Risk**

It is essential to identify currency risk exposure at both the transaction and strategic level.

- Assess all outstanding foreign currency receivables and payables for transaction risk.
- Review consolidated accounts for possible translation risk, especially if the group includes significant overseas subsidiaries.
- Analyse how exchange rate shifts could affect sales, costs, and competition in the long term (economic risk).

### **Worked Example 1.1**

A UK company sells goods worth \$500,000 to a buyer in the US, payment due in 90 days. The spot rate today is \$1.25 = £1. If, by the settlement date, the rate moves to \$1.20 = £1, what is the effect on the sterling value the UK exporter receives?

> **Answer:**
> At \$1.25 = £1: £ received = \$500,000 ÷ 1.25 = £400,000  
> At \$1.20 = £1: £ received = \$500,000 ÷ 1.20 = £416,667  
> The exporter will receive more in sterling if the dollar appreciates against the pound. Conversely, if the dollar had depreciated (rate moves to \$1.30 = £1), the sterling receipts fall, demonstrating transaction risk.

### **Managing Transaction Risk: Hedging Techniques**

To manage transaction risk, companies use several hedging methods:

- **Forward contracts:** Lock in an exchange rate now for settlement at a future date, eliminating uncertainty.
- **Money market hedges:** Use borrowing or lending in the foreign and home currency to fix the effective rate for a future payment or receipt.
- **Currency options:** Purchase the right, but not the obligation, to exchange currency at a set rate, protecting against adverse movements while keeping upside potential.

### **Worked Example 1.2**

A UK importer must pay €200,000 to a European supplier in three months. Worried that the EUR/GBP rate might rise, the importer enters into a forward contract to buy euros at a rate of €1.12 = £1. If the spot rate moves to €1.10 = £1 on payment day, how does the forward contract help?

> **Answer:**
> The forward contract allows the importer to buy €200,000 at €1.12 = £1:  
> £ payable = €200,000 ÷ 1.12 = £178,571.  
> If no hedge was used, at spot €1.10 = £1:  
> £ payable = €200,000 ÷ 1.10 = £181,818.  
> The forward contract protects the importer from the adverse movement, fixing the sterling cost and removing uncertainty.

### Managing Translation and Economic Risk

**Translation risk** is mainly an accounting issue. While firms sometimes hedge translation risk using balance sheet matching (offsetting net investments with borrowings in the same currency), most exam scenarios focus on identification rather than complex mitigation.

**Economic risk** is addressed through strategic actions such as:

- Diversifying sales and input sourcing across different currencies and markets
- Adjusting operational locations to reduce exposure
- Pricing flexibility and cost base alignment

### **Worked Example 1.3**

A Japanese carmaker with significant sales to the US fears the yen will strengthen against the dollar, reducing US-dollar-priced revenues in yen terms—a significant economic risk. What might the company do to manage this exposure?

> **Answer:**
> The carmaker could increase US-based production (costs in dollars) to match US sales, reducing net yen exposure. Alternatively, it might increase supplier contracts in dollars to partially offset revenue exposure.

### **Exam Warning**

> **Exam Warning**
> Do not confuse transaction, translation, and economic risk:
>
> - Transaction risk affects actual cash flows from specific contracts
> - Translation risk concerns consolidated financial reporting
> - Economic risk considers the long-term operations and value of the business

### **Revision Tip**

> **Revision Tip**
> When reading a scenario, always highlight:
>
> - Dates of payments and receipts (transaction risk)
> - Presence of foreign subsidiaries (translation risk)
> - Strategic impacts of exchange rate changes (economic risk)

## **Summary**

Currency risk is an important consideration for any international business. Transaction, translation, and economic risk each require clear identification and appropriate management strategies. For the FM exam, be sure you can define each risk, distinguish between them, and describe the main hedging options available.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define and distinguish transaction, translation, and economic currency risk
- Identify where each type of risk occurs in a business context
- Explain how foreign exchange rate movements impact transaction, reporting, and economic exposures
- Summarise traditional hedging techniques for managing transaction risk
- Understand that translation risk is mainly an accounting issue, and economic risk requires strategic action

## **Key Terms and Concepts**

- currency risk
- transaction risk
- translation risk
- economic risk

Currency risk identification and hedging - Transaction, translation, and economic risk