Risk Exposure Analysis

23/11/2020 1 By indiafreenotes

Risk exposure is the measure of potential future loss resulting from a specific activity or event. An analysis of the risk exposure for a business often ranks risks according to their probability of occurring multiplied by the potential loss if they do. By ranking the probability of potential losses, a business can determine which losses are minor and which are significant enough to warrant investment.

Risk exposure in any business or an investment is the measurement of potential future loss due to a specific event or business activity and is calculated as the probability of the even multiplied by the expected loss due to the risk impact.

There are two categories of risks: pure risks and speculative risks. Pure risks are unexpected risks that cannot be controlled, such as unexpected death and natural disasters. Speculative risks are voluntary risks that have an uncertain outcome, such as business investments or new product introductions. When things go wrong, speculative risks can result in losses such as brand damage, compliance failures, security breaches, and liability issues.

Risk exposure is a quantified loss potential of business. Risk exposure is usually calculated by multiplying the probability of an incident occurring by its potential losses.

When considering loss probability, businesses usually divide risk into two categories: pure risk and speculative risk. Pure risks are categories of risk that are beyond anyone’s control, such as natural disasters or untimely death. Speculative risks can be taken on voluntarily. Types of speculative risk include financial investments or any activities that will result in either a profit or a loss for the business. Speculative risks carry an uncertain outcome. Potential losses incurred by speculative risks could stem from business liability issues, property loss, property damage, strained customer relations and increased overhead expenses.

To calculate risk exposure, variables are determined to calculate the probability of the risk occurring. These are then multiplied by the total potential loss of the risk. To determine the variables, organizations must know the total loss in dollars that might occur, as well as a percentage depicting the probability of the risk occurring. The objective of the risk exposure calculation is to determine the overall level of risk that the organization can tolerate for the given situation, based on the benefits and costs involved. The level of risk an organization is prepared to accept is called its risk appetite.

Risk Exposure formula = Probability of Event * Loss Due to Risk (Impact)

Types of Risk exposure

  1. Transaction Exposure

Transaction Exposure occurs due to changes in the exchange rate in foreign currency. Such exposure is faced by a business operating internationally or dependant on components, which needs to be imported from other countries, resulting in a transaction in foreign exchange. Buying and selling, lending, and borrowing, which involves foreign currency, have to face transaction exposure.

The following risk involved in Transaction exposure:

  1. Exchange Rate: It occurs in case of the difference between the date of the transaction contract made and the transaction executed, for, E.g., Credit Purchase, Forward Contracts, etc.
  2. Credit Risk: Default risk in case the buyer or borrower is unable to pay.
  3. Liquidity Risk: In the case of contracts involving future date payments denominated in foreign currency, which might affect the credibility of the buyer or borrower.

Transaction Exposure is mostly managed using various derivatives contracts to hedge, so risk arises from these transactions will not affect income or expense.

  1. Operating Exposure

Measurement of business operating cash flow is affected due to a change in the exchange rate, which results in a growth in profit. Competitive effect and conversion effect will take place in the case of multinationals compare to local businesses operating in their domestic country. Such risk is managed by adopting a proper pricing strategy and reducing costs through local operations, outsourcing, etc.

  1. Translation Exposure

Translation Exposure arises due to changes in assets or liabilities of the balance sheet having a subsidiary in a foreign country while reporting its consolidated financial statements. It measures changes in the value of assets and liabilities of the company due to exchange rate fluctuation. Translation exposure does not affect the company’s operating cash flow or profit from overseas, but such risk only arises while reporting consolidated financial statements.

Translation Exposure in managed by the use of derivative strategies in foreign exchange to avoid ambiguity in the mind of investors of the company. The company accepts specific ways while maintains reporting financial statements.

Various Method

  • Current/non-current method
  • Monetary/Non-monetary method
  • Temporal
  • Current rate
  1. Economic Exposure

Change in value of business due to a change in the exchange rate. The cost of the business is calculated by discounting future cash flows discounted at a specific rate. Economic exposure is a mixture of relevant items in firms’ operations related to transaction exposure and translation exposure. The company’s operating exposure and transaction exposure makes economic exposure to a business. Economic vulnerability always exists in business due to its continuous nature. Present value calculations applied in all future cash flows of business as per expected and real change in the exchange rate affect the value of the business.