What’s the difference between translation risk and economic risk?
Offhand I’d guess economic risk is a synonym for transaction risk ?
Translation risk is accounting based. Translation risk is risk comming because of exchange rate changes for fixed sales amount. Economic risk is loss or gain in sales in a forigen country owing to changes in exchange rates.
GetSetGo Wrote: ------------------------------------------------------- > Translation risk is accounting based. Translation > risk is risk comming because of exchange rate > changes for fixed sales amount. Economic risk is > loss or gain in sales in a forigen country owing > to changes in exchange rates. that’s how i understood it as well. translation risk is the risk in translating the value of an asset back to domestic currency and economic risk is the risk that a fluctuating currency will affect that company’s sales. (ex. if domestic currency appreciates, sales will decrease as prices are now less competitive)
Translation risk is the risk associated PURELY on converting the value of foreign portfolio denominated in local currency back to domestic currency. Economic risk is the risk that the local return would be negatively influenced by the fluctuation of the FX. E.g. * exporter’s profit will dwindle if the FX (DC/FC) goes south. * importer’s profit will dwindle if the FX (DC/FC) goes north.
lxwqh Wrote: ------------------------------------------------------- > Translation risk is the risk associated purely on > converting the value of foreign portfolio > denominated in local currency back to domestic > currency. > > Economic risk is the risk of local return is > influenced by the fluctuation of the FX. > E.g. > * exporter’s profit will dwindle if the FX (DC/FC) > goes south. > * importer’s profit will dwindle if the FX (DC/FC) > goes north. Bingo!
could you please explain the difference between my answer and your’s regarding the second part, economic risk, lxwqh? i know there is a difference but i’m not clear… thanks.
i think your answer makes great sense too. 
didn’t read carefully when i was posting. also i look at this as an investment in a foreign assets, e.g. stock on a foreign exporter or foreign importer.
i like your answer better, i’m wondering if i put my answer on an actual question would i have points deducted? i feel like there may be a subtle difference between your answer and mine that i’m not picking up. anyone?
cfasf1 Wrote: >economic risk > is the risk that a fluctuating currency will > affect that company’s sales. (ex. if domestic > currency appreciates, sales will decrease as > prices are now less competitive) Not just sales but rather asset value. Let’s say you hold a stock of a Swiss company. You don’t care as much about the sales level as you care about the stock price.
sorry to drag this on… if we are then just thinking about asset value being affected by fx, i’m having a hard time distinguishing between translation risk and economic risk. the asset value will change as the underlying company’s sales and profit change because of fluctuating fx. so i thought the point of separating out economic risk from translation risk was to do just that, separate simple fx effects on asset values and the fx effects on the underlying economics of the entity in question… i think i’m overthinking it.
I agree its total assets and not just sales, I used sales to contrast with economic risk. I was posting in haste. My response was not the most optimal. I was just trying to explain the concept while running between meetings. Cheers
Look at in this way; also wanted to throw this in to enhance everybody’s memory about it: R(DC) = R(LC) + R(FX) * [1 + R(LC)] = R(LC) + R(FX) + R(FX) * R(LC) R(LC) : if the FX fluctuation correlates with R(LC); then R(LC) is affected by FX; this implies the economic risk. R(FX) : R(FX) * 1; this is the translation risk, it only deals with converting the foreign portfolio value to domestic currency. Also remember the minimum variance hedge ratio: h = COV[R(LC), R(Future)] / [sigma(future)]^2 = 1 +
thanks lxwqh. i clearly will have to review this again… it will click at some point. hopefully before june.
I think of it this way…by using key words to associate with each. Economic - Sales. I.e. Lower sales due to domestic currency appreciation. Translation - Accounting/Balance Sheet. I think of translation from L2. Risk of asset value depreciation on the balance sheet due to exchange rate fluctuations. Transaction - Cash Flows. I.e. you have a 2MM Euro cash flow due in 2 months…it is the risk of exchange rate movements that will affect that cash flow. In summary, Sales, Accounting, Cash flows. Hope this helps.
lxwqh Wrote: ------------------------------------------------------- > Translation risk is the risk associated PURELY on > converting the value of foreign portfolio > denominated in local currency back to domestic > currency. > > Economic risk is the risk that the local return > would be negatively influenced by the fluctuation > of the FX. > > E.g. > * exporter’s profit will dwindle if the FX (DC/FC) > goes south. > * importer’s profit will dwindle if the FX (DC/FC) > goes north. maratikus: Take it from lxwqh “As Is”, do not change a word from it:) BTW, you scare the *ell out of me whenever you post something because you suppose to be the blog in chief and solve my problems whenever I need help :).
I think part of the confusion is that currency risk is treated in two different secitons of the reading. Reading 41 distinguishes b/t translation and economic risk which is what lxwgh was talking about. Then in Reading 42 they break it out by transaction, translation and economic risk. Economic risk is the same in both but I don’t think transaction/translation are treated the exact same way in both readings. I think Reading 42 is more from an enterprise perspective, Reading 41 more from an investment perspective. Other than that, i can’t make heads or tails of it.
jbaldyga Wrote: >I don’t > think transaction/translation are treated the > exact same way in both readings. Translation risk is defined the same way. Transaction risk deals with currency risk of future cash flows. No inconsistencies.
tibwa Wrote: > BTW, you scare the *ell out of me whenever you > post something because you suppose to be the blog > in chief and solve my problems whenever I need > help :). Whatever helps you pass the exam …
maratikus Wrote: ------------------------------------------------------- > jbaldyga Wrote: > >I don’t > > think transaction/translation are treated the > > exact same way in both readings. > > Translation risk is defined the same way. > Transaction risk deals with currency risk of > future cash flows. No inconsistencies. yea i suppose you’re right. would you say that transaction risk applies to business operations only (or more commonly) where translation risk applies to both int’l investments and foreign business operations? Just trying to categorize these in my head so I can remember them.