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Translation Risk Translation risk is associated with one of many exchange rate risks. Translation risk specifically deals with the risk of a company’s equities, assets, liabilities, or income will change in value as a result of exchange rate changes. This occurs when a firm denominates a portion of its equities, assets, liabilities or income in a foreign currency. Basically, a company doing business in a foreign country will eventually have to exchange its host country’s currency back into their home country currency. Foreign exchange rates are constantly fluctuating. If exchange rates appreciate or depreciate, significant changes in the value of the foreign currency can occur. These significant changes in value creates translation risk because it creates difficulties in valuating how much the currencies are going to fluctuate relative to other foreign currencies. Translation risk is a The company’s financial statements of foreign subsidiaries-which are stated in foreign currency-must be restated currency for the firm to prepare consolidated financial statements. For example, U.S. companies must restate local Euro, Pound, Yen, etc. statements into U.S. dollars so the foreign values can be added to the parent’s U.S. dollar denominated balance sheet and income statement. This accounting process is called translation. Income statement and balance sheet are the two financial statements which must be translated. A subsidiary doing business in the host country usually follows the country’s’ translation method to be used. This depends on the subsidiary’s business operations. Subsidiaries can be characterized as either integrated foreign entity or self-sustaining foreign entity. Integrated foreign entity operates as an extension of the parent company, with cash flows and business lines that are highly interrelated with those of the parent. Self-sustaining foreign entity operates in the local economic environment independent of the parent company. Both integrated and self-sustaining foreign entity operates by using functional currency. Functional currency is the currency of the primary economic environment in which the subsidiary operates and generates cash flows from. In other words, functional currency is the dominant currency used by the foreign subsidiary in its day-to-day operations. Management must evaluate the nature and purpose of each of its individual foreign subsidiaries to determine the appropriate functional currency for each. There are three translation methods: Current rate method, temporal method, and U.S. Translation Procedures. Under the current rate method, all financial statement line items are translated at the “current” exchange rate. Under the temporal method, specific assets and liabilities are translated at exchange rates consistent with the timing of the item’s creation. Under the U.S. translation procedures, differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. The main technique to hedge translation risk is called the balance sheet hedging. Balance sheet hedging involves speculating in the forward market in the hope that a cash profit will be realized to offset the non-cash loss from translation. This requires equal amount of exposed foreign currency assets and liabilities on the firm’s consolidated balance sheet. If this can be achieved for each foreign currency. Net translation exposure will be zero. A change in the exchange rates will change the value of exposed liabilities in an equal amount, but in a direction opposite to the change in the value of exposed assets. If a firm translates by the temporal method, a zero net exposed position is called monetary balance. This is something that cannot be achieved by the current rate method because total assets will have to be matched by an equal amount of debt. But the equity section of the balance sheet must be translated at historic exchange rates. Companies can also attempt to hedge translation risk by purchasing currency swaps or future contracts. In addition, companies can simply request clients to pay in the company’s home country currency. Risk is then transferred to the client and the client is responsible for conducting the exchange when doing business in the company’s country of domicile.