What is the difference between Transaction risk and Translation risk?
Transaction risk is an exchange rate risk that arises from the time gap between entering into a contract and settling/executing it. It is more of a cash flow risk. That is, owing to fluctuations in the currency exchange rates, there is a possibility of incurring losses at the time of contract settlement. This type of risk can be mitigated with the help of derivatives such as futures and options.
An Indian company ‘A’ plans to import some goods from a US-based company ‘B’ in two months' time period. But there is uncertainty regarding the exchange rate on the day of executing the trade. In case the value of the Indian rupee depreciates against the US dollar, the company ‘A’ will have to pay more for the same trade. To eliminate this risk, it can enter into a futures contract with company ‘B’ stating the exchange rate at which it will buy goods from company ‘B’ after two months. Doing so will hedge company ‘A’ from any adverse movements in the exchange rates.
Translation risk is an exchange rate risk that arises from the conversion of one currency into another. It is more of valuation risk. There is no effect on the cash flows of the company. This type of risk is faced by companies that have branches or subsidiaries in foreign countries that trade in different currencies. So, the final conversion is done as per the currency in which the parent company trades. Furthermore, this type of risk can’t be mitigated with the help of derivative contracts.
A US company ‘X’ has a subsidiary in India that incurred a revenue of Rs 720 crore. For reporting its (parent company based in the US) revenue on a consolidated basis, it will have to convert this data and report in US dollars. So, if the USD/INR exchange rate is 72 (That is, 1 USD=Rs 72), the subsidiary’s revenue will be reported as USD 10 crore. In case the exchange rate rises to Rs 84, it will get converted to approximately USD 8.6 crore. The Indian subsidiary’s revenue hasn’t changed. But due to a depreciation of the rupee against the dollar, the parent company will now have to report the subsidiary company’s contribution as USD 8.6 crore as against USD 10 crore previously.