CIMA BA1 Syllabus D. The Financial Context Of Business - Impact of exchange rate changes - Notes 4 / 8
Impact of exchange rate changes
The impact of exchange rate movements can be beneficial or adverse for an organisation.
Impact on measures of economic performance (sales, costs, profits)
If the exchange rate moves AFTER a transaction (an export or an import) has been agreed, this risk is referred to as transaction risk.
Any losses incurred by a company due to transaction risk will be recorded in an exchange losses account and will reduce the company's profit.
Illustration 1
In July 20X1 Company A (whose local currency is the A$) agreed a contract with an export customer for €100,000.
The exchange rate at that time (the spot rate) was A$1: €1.6.
When the invoice was paid the exchange rate was A$1 : €1 .9
At the time the sale was recorded in the accounts of Company A, the expected revenue was €100,000 / 1.6 = A$ 62,500.
However the revenue that is received will be €100,000 / 1.9 = A$ 52,632.
The exchange loss (caused by the strengthening of the A$) will be A$62,500 - A$52,632 = A$9,868.
Impact on assets and liabilities denominated in a foreign currency
Many companies will hold foreign assets (eg factory, land) and/or foreign liabilities (eg a bank loan).
Movements in the exchange rate will affect the value in the domestic currency of foreign assets and foreign liabilities.
This is called translation risk.
| Foreign asset value will rise if: | Foreign liability value will fall if: |
|---|---|
| The exchange rate falls | The exchange rate rises |
| Foreign assets will be worth more in the domestic currency. | A business will pay less in its domestic currency to repay foreign loans. |
Illustration 2
It is approaching the year end, and Company A (whose local currency is the A$) has assets in euros worth €10 million.
These will be translated into A$ at the year-end exchange rate.
If the year-end exchange rate is $1: €1.6 these assets will be worth €10m / 1.6 — A$6.25m.
However, if the year-end exchange rate is $1 : €1.9 then these assets will be worth much less, €10m / 1.9 = A$5.3m.
Managing translation risk
To manage translation risk a company that has assets in a foreign currency will often match them with foreign liabilities (eg by borrowing in a foreign currency).