The Concept of Translational Currency Risk and its Features

This risk is known as a settlement, or balance sheet risk. Its source is the possibility of mismatch between assets and liabilities denominated in currencies of different countries. For example, if a British company has a subsidiary office in the U.S., it has assets denominated in U.S. dollars. If British companies do not have enough liabilities in U.S. dollars, offsetting the cost of those assets, the company is at risk. Impairment of the U.S. dollar against the pound sterling will reduce the book value of assets of subsidiary company, as the parent company's balance sheet will be expressed in pounds sterling. Similarly, a company with net liabilities in foreign currency will be at risk if the appreciation of the currency.

If the company believes that the translation risk does not matter, then there is no need to hedge that risk. In support of this view we can say that the reflection of changes in the balance sheet of assets and liabilities in their evaluation of the base currency is merely an accounting procedure that has no significance. The fact that the value of assets of the subsidiary in the United States, expressed in pounds sterling, fluctuates with the movement of the exchange rate of U.S. dollar against the pound sterling, can not affect the core business or profits (in dollars) subsidiary. Therefore, the cost of hedging the risk can be considered translational meaningless, since there is virtually no risk of losses from exchange rate fluctuations. This view is justified, if the exchange rate are considered as deviations from a relatively stable exchange rate. However, if there is a tendency to change course, the very trend may be significant, although the deviation from the course in one direction or another may have no value.

Attempts to determine the degree of translational risk causing a lot of controversy, mainly because of different accounting methods used for many years. In essence, we can assume that the parent company is exposed to losses from changes in exchange rates, which operates its affiliate, the full amount of the net assets of the branch. It is believed that the balance sheet risk arises when there is an imbalance between assets and liabilities denominated in foreign currencies. The parent company is exposed to the extent to which net assets of subsidiary Liabilities are not balanced.
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