 Foreign exchange rate risk is the natural consequence of international business activities in the world where movement in the value of relative currencies goes up and down and it is considered as a norm in the international foreign exchange market. Now this risk management is an important part in the international finance. This risk or exposure in the foreign exchange rate can be classified into three types namely short term exposure, long term exposure and translation exposure. First is the short term exposure. In fact, day-to-day exchange rate fluctuations create short term risk for the international corporations. The price variation in different currencies can affect the contractual agreement of the firm to buy and sell goods in a near future at the pre-set prices. Now how this risk emerges? Let take an example to understand. I assume the import of pasta from Italy at the rate of 8.4 euros per case. The spot exchange rate per dollar is equal to 1.5 euro. We need to import 10,000 cases which are expected to arrive in the coming 60 days. The firm will resell this imported pasta in US under the brand name of Impasta at a sale price of 6 dollars per case. This means that the per case dollar cost at the exchange rate of 1.5 dollar is equal to 5.6 dollars. And in this way the pre-tax profit on the sale of 10,000 cases will be equal to 4,000 dollars. And what will happen if the exchange rate in the next 60 days moves upward or forward? The ultimate effect will definitely be on the movement of the profit that will be changed accordingly. Now let take two scenarios in the movement of the exchange rate. In one scenario we have a higher movement whereas where the exchange rate of dollars moves from 1.5 to 1.6 and the other situation is the lower side movement where the exchange rate of dollar moves from 1.5 to 1.4 euro per dollar. So these are the two different high and low spot exchange rates for the dollar. Now the cost per case in terms of dollars will be equal to 5.25 dollars per case in the case of higher movement and 6 dollars per case in the case of low movement in the exchange rate. And if we determine the profit on the sale of 10,000 cases we see that where there is an upward movement of 1.600 per dollar the firm is earning 7500 US dollars. And whereas there is a lower side movement from 1.5 to 1.4 euro per dollar the firm is incurring no profit neither it is suffering any loss. So this is the movement in the exchange rate that turns the profit of a company into no profit situation. There are certain ways that a firm can adopt to reduce this short term exposure. First option is the hedging. Hedging refers to taking a low risk in order to avoid a higher risk. And this is basically the forward exchange agreement. In this example there is an option of 60 days forward rate let us say that is equal to the exchange rate of 1.58 euros per dollar. At this exchange rate the dollar a cost per case would be equal to 5.32 and using this data if the firm sells all 10,000 cases its profit will be equal to 6,800 US dollars. So entering into a forward exchange rate the firm has been able to earn a good amount of profit. The second option is to borrow dollars today convert them into euros then invest these euros for 60 days in order to earn interest based on interest rate parity and then this amount will be basically equal to entering into a foreign exchange contract. The second type of exposure is the long term exposure. This is basically the anticipated changes in the macroeconomic conditions that can affect the foreign operations of a multinational corporation. The changes in exchange rate can be very substantial for example a smaller movement in exchange rate can change the amount of profit by substantially. How we can hedge these long term exposures that is more tough than hedging for the short term risk exposure because there is the problem of non-existence of organized forward markets and also there is a mismatch between the foreign currency denominated assets and liabilities. So then how we can reduce this type of risk exposure first is option is to match up foreign currency inflows with the corresponding outflows second is to borrow in the foreign currency. But here is the fluctuations in foreign assets value can be offset by changes in the liabilities value of the foreign operations. So in this way we can minimize the negative effect of long term exposure of the foreign exchange rate. The third classification in this regard is the translation exposure. This refers to the translation of financial results of the value of foreign operations into home denominated currency. But this creates problem for the accountants as they are to translate foreign currencies into home currencies. There are certain issues that rise in currency translation for example what is the appropriate exchange rate that can be used for translating the foreign operations financial results into the home currencies denomination. Then the second issue is to accounting of gains and losses from this foreign currency translation. Now let consider an example there is a foreign subsidiary in Lilipsia who has a local currency called as GLIVER or GL. The exchange rate at the start of the year is equal to 2 GL per US 1 US dollar and at the start of the year we see the balance sheet of this foreign operation where the 1000 GL of assets is equal to liabilities of 500 GL int the rest is financed by equity and that is again 500 GL. Now we see that the exchange rate for 1 US dollar is equal to 2 GL and if we translate the GL denominated balance sheet into dollar denominated balance sheet at the start of the year we see that the assets are now equal to 500 US dollars and correspondingly liabilities and equities are equal to 250 dollars each. Now assume certain assumptions for whole of the year the foreign subsidiary has no business operations this means there is no net income during the year. The exchange rate changes to GL 4 for 1 US dollars and because the reason is the reason for this higher exchange rate is the higher amount of inflation in that foreign country. Now if we translate the dollar denominated balance sheet at the opening of the year into dollar denominated balance sheet at the end of the year we see now that the assets are equal to 125 dollars only with the corresponding values of liabilities and equity of 125 dollars each. Now at the start of the year if we convert this GL denominated balance sheet into dollar denominated balance sheet we need to convert the GL values at the exchange rate of 2 GL for 1 US dollar we see that now assets are equal to 500 US dollars with the corresponding value of 250 dollars each for liabilities and equity. Now let take certain assumptions the first assumption is that the foreign operations takes no business activity throughout the year this means there is zero profit for the foreign operations and the exchange rate per US dollar has risen to 4 from 2 and this higher exchange rate is due to the reason of higher inflation in that foreign country. Now at the end of the year if we convert if we prepare dollar denominated balance sheet we need to convert the opening GL denominated values into dollar denominated values at the exchange rate of 4 GL per 1 US dollar and now we see that the assets are now equal to 250 US dollars whereas the corresponding values of liabilities and equities are equal to 125 dollars each. Now there is a significant difference the opening and closing dollar denominated values we see that the dollar denominated value of equity has decreased from 250 dollars at the start of the year to 125 US dollars at the end of the years this means there is decrease in the value of equity despite of the fact that no operations taken place during the year still there is a loss of 125 US dollars and now that loss will definitely go to the owners in the home country how this loss can be counted for in the books of the home country there are two options as we are in translation exposure the first this loss of 125 US dollars may be reported in the parent companies profit and loss account or alternatively this loss of 125 US dollars that is due to the translation of GL denominated financial results into dollar denominated financial results and this loss is known as translation loss so as an alternative this translation loss can be converted into home currency and in the balance sheets of the parent company this loss can be placed under its equity section.