RISKS FACED BY CORPORATE ENTITIES
1. Transaction Risk :
In international trade, exporters and importers decide on the acceptability of the
contract based on the exchange rate information available to them at the time of
accepting the contract. These contracts however involve a time gap for fulfilment
during which period, the exchange rate may move adversely against the contracting
party. Such risk is called transaction risk.
Transaction risk is inherent in every contract but can be managed through the use of
internal and external hedging mechanisms. External hedging mechanisms are
generally called derivatives. Derivatives such as forward contracts, future contracts
and option contracts are used to hedge transaction risk.
2. Translation Risk :
MNC’s create assets and liabilities in different countries and currencies. The book
entries for such assets and liabilities are passed at the applicable exchange rate
prevailing on the respective transaction date. When consolidating the accounts on
the date of the balance sheet, it is necessary to provide for the realizable value of the
foreign currency element in these assets and liabilities. This does not constitute
revaluing the assets and liabilities at the market prices but marking to market the
realizable value of the foreign currency element. This is done by adjusting the profit
or loss due to translation to the P/L A/c, Both debits and credits to the P/L A/c have
negative features and are therefore undesirable. The risk of such translation of asset
and liability values for consolidation of the balance sheet is called Translation risk or
Balance sheet risk.
This risk does not involve any actual cash profit or loss, but adjustments are made on
notional basis only. It is therefore, not possible to use external derivatives to control
this risk. Management of this risk is generally done through internal processes such
as creating equal amount of assets and liabilities in all foreign currencies so that the
net effect of adjustment on the P/L Ac is zero. Alternatively, the net effects of such
adjustments are made directly to shareholders equity and not to the PIE account.
This eliminates distortation of the P/L account and it reflects the actual performance
for the given period.
3. Economic risk :
Economic risk can be defined as business risk arising out of changes in the economic
environment. For example, a change in the domestic exchange rate may provide an
advantage to a competitor which may adversely affect the capacity of the enterprise
to compete effectively. Economic risk cannot be anticipated nor can it be quantified
and hence cannot be hedged through the use of external derivatives. Being a
business risk, it is accepted as the risk of being in business. MNC’s generally have
alternate business strategies framed for dealing with business risks.