Translation Risk
Translation risk does not involve cash flows.
Investment (land and building) in foreign currency will result in lower amount in balance sheet prepared in home currency due to depreciation of foreign currency.
Liability (Bank loans) in foreign currency will result in higher amount in balance sheet prepared in home currency due to appreciation of foreign currency.
Transaction risk is long-term risk because it is subject to long-term investments & liabilities.
Translation risk can affect key ratios such as profitability, gearing and investor ratios.
Translation risk can result in violation of loan covenants about maximum gearing level, which should not be exceeded. Reduction in assets leads to reduction in equity resulting in higher gearing ratio.
Moreover, organization may find difficulty raising finance as lenders evaluate credit risk by calculating gearing ratios.
Similarly, transaction risk can result in reduction in share price and market capitalization of the organization due to reduction in equity.
ROCE will also increase without any improve in performance of the organization. Managers will be wrongly rewarded, if ROCE is used for calculating profit related pay (PRP).
Translation risk can be controlled by organization through careful planning and using matching principle.
