Definition of Translation Risk
Translation risk arises when foreign financial statements of a company is converted into domestic currency. This risk may adversely affect firm’s reported financial statements, or related financial ratios or borrowing covenant compliance, resulting from changes in the rates at which foreign currency denominated assets and liabilities are translated into the reporting currency.
Translation risk commonly applies to the translation of monetary assets and liabilities. This risk may also apply to the consolidation of overseas subsidiaries into group financial statements.
Characteristics of Translation Risks
The Characteristics of Translation risks are presented as follows:
Reporting in different currency:
Translation risk arises due to reporting in different currency. Say, a company has a subsidiary, if it wants the results of that subsidiary to incorporate or consolidate with the parent company, then translation risk arises.
No Cash flow implication:
These risk is not associated with the cash flows and therefore does not require hedging.Matching technique of hedging may be used here to eliminate the risk.
This is not hedged due to non implication of cash flow. However, matching technique of hedging may be used to hedge the risk.
How Translation Risk can be Minimized
Translation risks can be minimized by by minimizing the the scale of any foreign denominated assets, liabilities, income or expenses. The scale of foreign net assets could be reduced by financing with a foreign currency loan bringing the net assets of the overseas subsidiary to zero. Alternatively, a long term currency swap could be used to switch the exposure on the sterling loan into the relevant foreign currency.
Translation risk poses a serious threat to a Multinational Company (MNC). The country which have high political unrest situation and where the currency fluctuation is very common, translation risk may common there. Exchange rates could be change between quarterly financial statements and that may arise significant variances between the reported figures from quarter to quarter. Translation risk may affect on the stock price of the company. A company may minimizes translation risk by purchasing currency swaps or hedging through future contracts. On the other hand, a company may request to clients to pay for the goods and services in the currency of the company’s country domicile.