What is Risk Exposure?
Risk exposure in any business or an investment is the measurement of potential future loss due to a specific event or business activity and is calculated as the probability of the even multiplied by the expected loss due to the risk impact.
The calculation of probability related to a particular event resulting in loss to the firm is an integral part of risk analysis. Therefore, understanding, estimating, and taking necessary precautions to avoid or minimize that risk is an essential decision for management.
How to Calculate Risk Exposure?
Although specific risk involved in business cannot be predicted and controlled, the risk which is predictable and can be managed are calculated with the following formula:
Risk Exposure formula = Probability of Event * Loss Due to Risk (Impact)
There are three investment options available for an investor, which he needs to decide. An investor wants to invest $500,000 in the market for one year.
An investor has to make a decision in which investment option he prefers to invest. Although investment option C looks attractive with higher returns, the risk involved is also higher, 12%.
If an investor decides to divide investment into all three options, risk exposure would be adjusted, and he will benefit from all three assets.
The risk column in the table represents the probability of loss on investment.
Types of Risk Exposure with Example
There are four types of Risk Exposures:
#1 – Transaction Exposure
Transaction Exposure occurs due to changes in the exchange rate in foreign currency. Such exposure is faced by a business operating internationally or dependant on components, which needs to be imported from other countries, resulting in a transaction in foreign exchange. Buying and selling, lending, and borrowing, which involves foreign currency, have to face transaction exposure.
The following risk involved in Transaction exposure:
- Exchange Rate: It occurs in case of the difference between the date of the transaction contract made and the transaction executed, for, E.g., Credit Purchase, Forward ContractsForward ContractsA forward contract is a customized agreement between two parties to buy or sell an underlying asset in the future at a price agreed upon today (known as the forward price)., etc.
- Credit Risk: Default risk in case the buyer or borrower is unable to pay.
- Liquidity Risk: In the case of contracts involving future date payments denominated in foreign currency, which might affect the credibility of the buyer or borrower.
Transaction Exposure is mostly managed using various derivatives contracts to hedge, so risk arises from these transactions will not affect income or expense.
Indian Mobile manufacturers operating in India need to import certain internal parts of mobile from China and the United States. Price total imports of components required for manufacturing a single mobile phone costing ¥500 and $50. Company manufacture 100,000 mobiles every month.
Current Exchange Rate
Current Manufacturing Cost of A Single Unit
Current Exchange Rate
Change in Manufacturing Cost per Unit
Total Manufacturing Cost
Manufacturing Cost per month increased by ₹ 5,00,00,000 due to a change in the exchange rate.
#2 – Operating Exposure
Measurement of business operating cash flow is affected due to a change in the exchange rate, which results in a growth in profit. Competitive effect and conversion effect will take place in the case of multinationals compare to local businesses operating in their domestic country. Such risk is managed by adopting a proper pricing strategy and reducing costs through local operations, outsourcing, etc.
US Refrigerator Manufacturer operating in the Indian market faces loss due to appreciation in the dollar resulting in less cash flow.
#3 – Translation Exposure
Translation Exposure arises due to changes in assets or liabilities of the balance sheet having a subsidiary in a foreign country while reporting its consolidated financial statements. It measures changes in the value of assets and liabilities of the company due to exchange rate fluctuation. Translation exposure does not affect the company’s operating cash flow or profit from overseas, but such risk only arises while reporting consolidated financial statementsConsolidated Financial StatementsConsolidated Financial Statements are the financial statements of the overall group, which include all three key financial statements – income statement, cash flow statement, and balance sheet – and represent the sum total of its parents and all of its subsidiaries..
Translation Exposure in managed by the use of derivative strategies in foreign exchange to avoid ambiguity in the mind of investors of the company. The company accepts specific ways while maintains reporting financial statements.
- Current/non-current method
- Monetary/Non-monetary method
- Current rate
US company has a subsidiary in Europe use various methods while reporting the following is one method to calculate translation exposure. Following is a Monetary/Non-monetary way.
#4 – Economic Exposure
Change in value of business due to a change in the exchange rate. The cost of the business is calculated by discounting future cash flows discounted at a specific rate. Economic exposure is a mixture of relevant items in firms’ operations related to transaction exposure and translation exposure. The company’s operating exposure and transaction exposure makes economic exposure to a business. Economic vulnerability always exists in business due to its continuous nature. Present value calculations applied in all future cash flows of business as per expected and real change in the exchange rate affect the value of the business.
Us company operating through a subsidiary company in Europe faces loss due to a change in the exchange rate in a year.
Income changed because of exchange rate fluctuation, which will change income from operations and the value of a business.
Risk Exposure is essential to factor in any business, whether big or small, since it gives us an estimate of risk involved while undertaking certain activities, changes in policy, or change in operations. The difference in the exchange rate is an integral part of today’s business world since import and export; outsourcing of services is a large part of the business of many multinational organizations. Many companies operating in the domestic market still needs some help through imports and receive benefits of exports. Right pricing, policy, and operating strategy will help a business to manage overall risk exposure.
This has been a guide to what is risk exposure and its definition. Here we discuss types, examples, and the calculation of risk exposure. You may learn more about financing from the following articles –