maratikus, I don’t think you have the schweser notes (might be different in the sauce), but I think jbaldyga is right. The first example in reading 41 for schweser definitely deals with cash flows and is calling it translation risk. “Assume a US investor makes a 90 day euro denom investment valued at 1 M euro. The spot exchange rate is $1.2888/Euro, so the US investor must invest $1.2888/Euro * 1 M Euro= $1.2888 million. In 90 days, the spot rate is $1.2760/Euro, and the investment is value at Euro 1,050,000. When the investment is liquidated and TRANSLATED back in US dollars, the investor receives Euro 1,050,000 * $1.2760/Euro = $1,339,800.” *************************** I think this is confusing because it is both cash flows and accounting are treated as translation risk in reading 41 as opposed to reading 42 when cash flows are treated as transaction risk and accounting values are treated as translation risk. Doesn’t that example look like cash flows to you?
I see your point, mwvt. I was refering to Secret Sauce that consistently differentiates between translation and trasaction risk.
I think that reading 42 is the better description (as it is in the sauce). I am going to go with that one.
I read this one more time and would like to get others thoughts: Economic risk: It appears to me that this is essentially a form of opportunity cost or the amount of business that is not transacted because of adverse changes in the exchange rate. This is why the sales example cited above several times is used here. Translation risk: Accounting risk or financial statement type of risk. This is mainly just the risk of adverse movements in asset values or profits due to changes in exchange rates to affect the BS or IS. Transaction risk: This has to do with cash flows. So it is either the risk of cash flows received being diminished by exchange rate movements or cash flows you have to pay becoming more expensive because of exchange rate movement. So in summary economic risk is the business that isn’t done while transaction is the risk on current cash flows (in or out). Translation is just on paper.
Poulin has it all perfectly stated Translation - change in value on assets you hold due to change in exchange rates Transaction- changes in cash flows expected due to change in exchange rates from now until the day the cash flow is received Economic - sensitivity of economic transactions to currency - some might not happen, some might happen at decreased levels etc ( for the first two the assets and cash flows are already committed, for the third one is something affecting the future)
Just in case somebody might find this more helpful. This is how I remember it 1. Transaction Risk: When a firm or individual has a receivable or a payable in a foreign currency the foreign exchange rate may change, causing an increase in the liability of the home country’s currency or a decrease in receipts in the home country’s currency. 2. Translation Risk: When a home country entity is required to consolidate its foreign subsidiaries’ income statements and balance sheets into the home currency. Exchange rates may change, causing an increase in liabilities or a decrease in assets as measured in home country currency terms. 3. Economic Risk: The effect of exchange rate changes on the long term expected income streams, i.e., expected net wealth of home country stockholders. This risk is usually managed with physical location of assets and liabilities.
So does anyone know what is the hedge ratio of Translation risn and Economic risk?