The terms exchange exposure and exchange risk is often used interchangeably, but they have their independent meanings. It is through the exchange exposure that a firm faces exchange risk.
Exchange Exposure and Exchange Risk
Exchange Exposure is defined as the extent to which transactions, assets and liabilities of anenterprise are denominated in currencies other than the reporting currency of the enterprise itself. The reporting currency is normally the national currency of the parent company. Exposure arises because the enterprise denominates transactions in a foreign currency or it operates in a foreign market. The exposure is measured by the value of assets and liabilities or transactions denominated in foreign currency.
Exchange risk is defined as the net potential gains or losses, which can arise from exchange rate changes due to the foreign exchange exposure of an enterprise. It is possible that an adverse exchange rate movement may turn an otherwise profitable deal into a loss. For instance, if an export deal is struck with a profit margin of 10%, and meanwhile the foreign currency in which the deal is denominated depreciates by 15%, the result would be a loss of about 5%. It is also possible that the unexpected movement in the exchange rate is favorable and brings windfall profits. The concept of exchange risk covers both the possibilities.
Difference Between Exposure and Risk
Exposure relates to the total value of assets, liabilities or cash flows of an enterprise denominated in foreign currency, which exchange risk relates to the excess or shortfall in the cash flows or value of assets or liabilities likely to arise on account of exchange rate fluctuations. Thus exposure relates to the absolute value of an asset or liability involved, and the risk relates to the changes in the value. It is the exposure that leads to risk through exchange rate changes.