Foreign exchange risk

A bank also holds assets and liabilities in foreign currencies which impacts its
earnings and capital due to the fluctuations in the exchange rate, this is known
as foreign exchange risk the exchange rates cannot be predicted for the future
period, it may either rise or fall regardless of the estimations and predictions.
These uncertain variations which are undesired and unanticipated possess a
threat to the banks earnings as well as its capital.

Types of Foreign exchange Risk

1. Transactional Exposure
2. Economic Exposure
3. Translational Exposure
4. Operational Exposure

Transactional Exposure
Transaction exposure is a kind of risk where cross currency transactions are
involved (international Trade) where multiple currencies come in from various
countries. In other words if a company id dealing with another foreign company
where it would have to make a payment in foreign denomination and the
exchange rates fluctuates before the final settlement then this known as
Transactional Exposure.
For example if an Indian company is doing business with a US based company
and it has a receivable of USD 5000 due in five months time but at the same the
the dollar depreciates relative to the Indian rupee the the Indian company will
face a cash loss but on the other hand if it had to payable to the US company
then the Indian company would have made a gain due to the depreciation of the
US dollar.
Thus a cross currency contract between the two firms located in different
countries agree for a specific amount of money and goods. However the contract
value may change due to fluctuations in the foreign exchange rate. This risk of
change in the exchange rate is called Transaction Exposure. The time gap
associated between the agreement and the final settlement determines the risk
in the foreign exchange rates. Greater the time gap higher the risk. However
companies use hedging techniques to save themselves from transactional
exposure.

Operating exposure
The extent to which a companys future cash flows are affected due to the
changes in the price and most importantly due to the changes in the exchange
rate is known as the operating exposure. In other words an operating exposure is
the risk that the companys revenue is affected due to inflation rate and change
in the exchange rates.
Like transactional exposure, operating exposure also involves the actual or
potential gain or loss, but the transactional exposure deals with particular
transactions of the company while operating exposure deals with the macro level
exposure where not only the company involved gets affected but the whole
industry observes change along with the change in the inflation rate and
exchange rates thus the entire economy is exposed to foreign exchange risk with
the operating exposure.
Operating Exposure is difficult to identify as the cash flows largely depend upon
the companys input and the prices of its output which gets altered significantly
with the change in the foreign exchange rates. Operating exposure relates to
unseen challenges from the competitors, entry barriers etc which are subjective
in nature and are interpreted differentially by different experts. Thus, competitive
position of the company is influenced substantially by operating exposure.

Translation Exposure
Translation exposure is also known as accounting exposure. It is the risk arising
due the translation of assets held in foreign currency or abroad changes due to
the movement in the foreign exchange rates. The translation exposure is
concerned with recorded profits and the balance sheet values and does not
affect the overall value of the company. Since the losses or gains due to the
translation of financial items has no significant impact on the stock prices of the
company

Foreign Exchange Risk in commercial bank

Commercial Banks actively deal in foreign currencies, they hold foreign
denominated currencies and are therefore continuously exposed to foreign
exchange risk. The foreign exchange risk in a commercial bank mainly arises
from its trade and non-trade services.
The commercial bank is exposed to foreign exchange risk only to the extent to
which it has not hedged or covered its position. Wherever there is uncertainty
that the future exchange rates will affect the value of financial instruments, there
lies foreign exchange risk of a commercial bank. Foreign exchange risk does not
lie where the future exchange rate is predefined by using different instruments
and tools by the bank.
Source: http://old.fxstreet.com/education/forex-basics/the-six-forces-of-forex/2006-06-29.html