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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A US-based manufacturer has signed a contract to buy equipment from a German supplier, payable in euros in six months. The firm's reporting currency is the US dollar. Which type of foreign exchange exposure does this payable most directly create?

A fixed euro payable due in six months creates transaction exposure, because the dollar cost of settling a contractual foreign-currency cash flow varies with the exchange rate. Translation exposure concerns consolidation of foreign statements, and economic exposure concerns uncontracted, long-run competitive effects.

  1. ATransaction exposureCorrect
  2. BTranslation exposure
  3. CEconomic (operating) exposure
  4. DSovereign exposure

Explanation

A contractual cash flow denominated in a foreign currency and settled in the future creates transaction exposure, because the dollar value of the payment changes with the EUR/USD rate. Translation exposure relates to consolidating foreign subsidiary statements, and economic exposure relates to the effect of exchange rates on long-term competitiveness and future cash flows not yet contracted.

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