 Hello and welcome to this session in which we will discuss the exchange and economic risks in international operations. Those two concepts relate to potential losses that can arise due to exchange rate fluctuation because the exchange rate goes up and down and that's going to affect you if you're operating on an international level or macroeconomic changes. Exchange rate risk is also known as currency risk or foreign exchange risk. It basically refers to the potential losses that can arise from changes and the exchange rate between two currencies. Well if you're operating in a different country you're going to have to deal with the foreign currency or if you're selling or buying from a foreign currency you do have that risk and we could have two types of risks under the exchange risk. We could have transaction risk, we could have translation risk and we need to define each one of these risks. Now we also have economic risks refer to the potential changes in the business operations and profitability due to the broader economic environment. So that has nothing to do with the exchange risk although they affect each other but you want to see the separate pieces so you see how they affect each other. For example changes in gross domestic product of the country in which you are either selling to, buying from or operating in. Any changes in gross domestic product GDP it's going to affect you. Changes in interest rate in that particular country changes in inflation and you're going to see all these factors one two and three they are interrelated and those factors one two and three are interrelated they are related to the currency risk. So they're all interrelated but you want to know how each one affects the other, how each one affects the other but again it's all interrelated. Let's go ahead and start by discussing transaction risk. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead start your free trial today. Transaction risk is as the word suggests it's a transaction. It's basically what is transaction? Transaction is buy, sell either buy something or sell something. It occurs when a company engage in international trade that has a receivable and payable. When you buy stuff you might have an accounts payable when you sell stuff you might have a receivable assuming import export. So you have either a payable or receivable denominated in a foreign currency. So what is the risk? The risk is you might have unfavorable changes in the exchange rate between the time the deal is made and when the payment is received or made. So what happens is this, when do you have a receivable? You have a receivable, you make a sale here and you have an AR but you will not be receiving the cash until maybe 30 days or 60 days later. Well what's going to happen is this, you have a receivable in a foreign currency. By the time you receive the cash you could have more of your local currency or less because defluxuation could be for you or could be against you because the foreign currency goes up and down. Same concept you have an accounts payable in a foreign currency. You're going to have to make a payment later. Well you might have to pay more, you might have to pay less. So that's the risk of the transaction risk, currency transaction risk. So suppose a US company agrees to sell goods to a British company. So the British company is the foreign company for 100,000 British pounds expecting to receive $130,000 when the deal was made. When the deal was made each British pound will give you $1.30. Now by the time the British made the payment because you remember you sold it on credit the exchange rate was each British pound can only buy you $1.20. Well in this case when you receive the $100,000 you go to the market to turn it into US dollar you only get $120,000. Well you lost $10,000. Now this is this is the risk itself. Now do we deal with that risk? Of course we're going to learn later that we have various hedging instruments where we can hedge this transaction but you need to know what is what is a transaction risk. Here's what you need to know for now. If you have an account receivable in a foreign currency, if you are expecting to receive the money you want the foreign currency to strengthen and in other words you want your local currency to weaken. Why? Because if the foreign currency strengthens you can buy more local currency and your goal is to have more of your local currency because that's where you operate. If you have an accounts payable and a foreign currency you want the foreign currency to weaken. Why? Because you want your local currency to buy you to buy you more because if your local currency is strong and the foreign currency not the foreign current the foreign currency is weakened then you can buy more of it. Translation risk it's related to the exchange risk but translation risk exists when you operate overseas when you have subsidiaries. Exchange risk is when you buy and sell import export. Here you have an you have an operation in Europe and Asia and now you have to do what? You have to translate your financial statement and that's why it's called a translation risk. Translate mean take your financial statements that are in Europe that are prepared based using the euro currency and translate those into US dollar. So translation risk is the rest of the company's financial statement are affected when they have to consolidate from various different currencies to a single currency. Single currency whatever your home currency is for talking about the United States it's the US dollar. Again this happens when you have to consolidate for example consider a US-based company with a subsidiary in China. The financial performance of the subsidiaries must be translated from the Japanese yen to US dollar. So at the end of the reporting period you cannot tell the user this is how much I have sales in yen you have to translate everything to US dollar. If the yen depreciates against the dollar between the start and the end of the physical year the translated of the the translated financial statement of the Japanese would show reduced revenue and profit. Why? Because the currency went down in value the currency went down in value although the subsidiaries has been performing well. Sales are increasing everything is good we have good profit but when we translated the financial statement it looked as from a US dollar we have less US dollar compared to the prior year. This create a translation risk this is what a translation risk is. Now translation risk would learn more about this we could have a temporal method or we could have the current method to use and this topic is discussed more in depth in financial accounting and reporting. I know you're looking forward for that if you haven't took that topic yet. Of course far hat lectures can help. Now let's move on to the economic risks one of the economic risks is GDP grows domestic product GDP we have a separate recording about it it's a measure of the economic activity within a country within the border of that country it's the total value of goods and services produced over a specific period of time within that countries. So if you are the country's border so if you are operating in a foreign country you want to look at their GDP because when the GDP is growing means it's healthy it indicate that businesses and customers are spending more so if you are operating you have businesses over there or you're selling to that country that's great. Think about German companies or US companies US companies that sells to Europe they want Europe to be the one well why because if they want to sell their vehicles their computers their phones well if Europe is the one well or China is the one well they can afford to buy our product so you want to have a healthy GDP to your ending destination which often leads to increase in demand for both domestic and imported goods and services. So for companies operating internationally if you are located in those countries this could mean a larger potential market and higher sales people are spending more you gotta capture some of that increase in market well the flip side is if the GDP is contracting means it's weakening it's going down domestic businesses and consumers are likely to cut back and guess what you are part of that economy they will cut back on spending and as a result it leads to a reduced in demand for imported goods and services you want a higher GDP so the demand for your goods go up as well go up as well let's take a look at interest rate and you're gonna see as I told you at the beginning GDP interest rate and inflation they all affect each other and the effect of currency what is interest rate interest rate as the is the cost of borrowing this is what the interest rate is it's a cost of borrowing the cost the renting money if you want to rent money well they will they you have to pay interest higher interest rate make borrowing more expensive which can deter businesses from taking on that so interest rate is high you are you are going to spend less you are I'm sorry you're gonna you are going to borrow less to finance your expansion well if you borrow less well you're not going to expand so you cannot expand your operation so do you want interest rate to be low or high you want lower because that's going to reduce the cost of operating the business also higher rate deter new investments why because when interest rate is higher remember you borrow money to make investments when interest rate is higher your cost is higher it means you have to make extra profit it makes it harder for new investments because you have to make extra effort just to cover the interest rate and higher interest rate also will do what will increase the cost of doing business if you have a loan your cost of that loan is higher it's lowering your profit lowering lowering the value of your company which is the growth rate of your company higher interest rate can also deter consumers and businesses people spend less why because it's going to cost them more likewise with businesses and guess what when so simply put when interest rate goes up spending goes down gdp goes down right and the opposite is true the opposite is true lower interest rate would encourage people to spend will invite new investments because the cost of money is cheaper the profitability of companies is higher so notice the old code seed with each other inflation is another economic risk again you can see inflation interest and gdp they're all interrelated inflation refers to the rate at which the general level of prices for goods and services is rising and this can significantly impact international operation in various ways one is interest rate here's what happened when inflation kicks up the central banks of that country they will raise interest rate and what do we know about interest rates of it if the overall prices are up the central banks they want to slow down the economy because the prices of everything is going up how do you kind of put a break on this you make the cost of money higher to slow things down there's always a perfect balance and usually you know it's hard to get to the balance but that's what happened central banks often respond to high inflation by raising interest rate and we know what happened when you have interest rate to slow down the economy and reduce inflate inflationary pressure also it's gonna affect the exchange rate inflation can influence the exchange rate between two currencies how well if you have high inflation if you have high inflation it means your money is not worth much that's what high inflation is you have more money but it's buying you less what does that mean it means your currency is depreciating in value by its nature inflation means your your your currency is worthless it means it depreciate now here's what happened there's good news bad news here high inflation it makes your product if you are selling cheaper why because you become competitive your currency is cheaper it's cheaper for other for other countries to buy your currency and therefore buy your product now on the flip side if your business needs to import goods or import material or have input cost in a foreign currency the cost of the input is much more expensive so depending on what side of the coin you are are you on the exporting side importing side but remember as i just told you higher inflation is higher interest higher interest and if you have high inflation and high interest usually you know GDP will shrink then then you have the process again they would lower interest the lower inflation GDP will go up conversely low inflation can lead to appreciation appreciation of the currency the currency now goes up why because you have low inflation well under those circumstances like german companies don't like what wonder when their currency goes up it makes german product much more expensive in the us guess what but if they want to buy goods from the us or come come to the us to new york i don't know they want to come to new york but if let's assume the york for tourism then why not it's cheaper for them because the euros will buy the more usd just just to sum it up remember those those are all interrelated topics GDP interest rate and inflation and those affect foreign currency and foreign currency exchange rate will give you transaction risk and translation risk you need to understand them and how they all fit together what should you do go to farhat lectures work mcq's that's going to help you understand this concept better good luck study hard and of course stay safe