To realize the domestic value of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic how to manage forex risks. Applying public accounting rules causes firms with transnational risks to be impacted by a process known as “re-measurement”.
The current value of contractual cash flows are remeasured at each balance sheet. Such exchange rate adjustments can severely affect the firm’s market share position with regards to its competitors, the firm’s future cash flows, and ultimately the firm’s value. Economic risk can affect the present value of future cash flows. A firm’s translation risk is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiaries from foreign to domestic currency. A firm has contingent risk when bidding for foreign projects or negotiating other contracts or foreign direct investments. Such a risk arises from the potential of a firm to suddenly face a transnational or economic foreign exchange risk, contingent on the outcome of some contract or negotiation.
For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an immediate receivable. Financial risk is most commonly measured in terms of the variance or standard deviation of a variable such as percentage returns or rates of change. In foreign exchange, a relevant factor would be the rate of change of the spot exchange rate between currencies. Firms with exposure to foreign exchange risk may use a number of foreign exchange hedging strategies to reduce the exchange rate risk. Firms may adopt alternative strategies to financial hedging for managing their economic or operating exposure, by carefully selecting production sites with a mind for lowering costs, using a policy of flexible sourcing in its supply chain management, diversifying its export market across a greater number of countries, or by implementing strong research and development activities and differentiating its products in pursuit of greater inelasticity and less foreign exchange risk exposure. Translation exposure is largely dependent on the accounting standards of the home country and the translation methods required by those standards.
For example, the United States Federal Accounting Standards Board specifies when and where to use certain methods such as the temporal method and current rate method. Many businesses were unconcerned with and did not manage foreign exchange risk under the Bretton Woods system of international monetary order. Fundamentals of Multinational Finance, 3rd Edition. Managing Global Financial and Foreign Exchange Risk.