In a short essay, describe the three types of currency exposure, and explain how foreign currency translation works

What will be an ideal response?

There are three main types of currency exposure: transaction exposure, economic exposure, and translation exposure. Transaction exposure is currency risk firms face when outstanding accounts receivable or payable are denominated in foreign currencies. Resulting gains or losses affect the firm's value directly by affecting its cash flows and profit. Translation exposure results when an MNE translates financial statements denominated in a foreign currency into the functional currency of the parent firm, as part of consolidating international financial results, that is, combining and integrating the financial results of foreign subsidiaries into the parent firm's financial records. Economic exposure (also known as operating exposure) results from exchange-rate fluctuations that affect the pricing of products and inputs, and the value of foreign investments. Exchange rate fluctuations help or hurt sales by making the firm's products relatively more or less expensive for foreign buyers.

A critical task in international accounting is foreign currency translation, or translating data denominated in foreign currencies into the firm's functional currency. Each of the firm's subsidiaries abroad normally maintains its financial records in the currency of the country where it is located. When subsidiary results are consolidated into headquarters' financial statements, they must be expressed in the parent's functional currency. When headquarters consolidates, foreign currencies are translated into the functional currency using one of two methods: the current rate method or the temporal method. The current rate method translates foreign currency balance sheets and income statements at the current exchange rate–the spot exchange rate in effect on the day (in the case of balance sheets) or for the period (in the case of income statements) the statements are prepared. This method is typically used when translating records of foreign subsidiaries that are considered separate entities, rather than part of the parent firm's operations. The current rate results in gains and losses, depending on the exchange rates in effect during the translation period.