Translation risk is a type of rate of exchange risk that a business assumes when engaging in activities that involve dealing with international currencies or other assets as well as domestic currency and assets. The risk comes in due to the volatility of the foreign exchange or Forex market, and the potential for those holdings to increase or decrease in value based on what is happening in that market. The degree or proportion of translation risk that is assumed depends greatly on the amount of international holdings and assets that the company controls in relation to its domestic assets and how the business uses various strategies to protect the investment in foreign markets from exchange rate fluctuations.
Managing the degree of translation risk requires that company officers be aware of what is happening in the Forex market and how those events impact international investments and holdings. This is particularly true when it comes to generating business volume in a foreign nation. Depending on how the rate of exchange fluctuates between the domestic currency of the business and the currency native to the country in which the foreign operation resides, there is the possibility of experiencing significant gains or running the risk of incurring a loss on the sales revenue generated for a specified period of time.
There are several strategies that companies use to help reduce the degree of translation risk and still actively pursue business in a number of foreign locations. One approach is to make sure the balance between domestic and international holdings is kept within acceptable parameters. This makes it easier to absorb losses that may be incurred due to the shifts in the exchange rate. In addition, some companies will make use of strategies such as currency swaps or creating hedges with the use of futures contracts that can be executed in the event a shift in the rate of exchange is unfavorable.
While it is possible to minimize exposure to translation risk, there is no way to do away with the risk altogether short of choosing to not establish business operations in foreign markets. For this reason, taking the time to assess the potential for establishing a presence in those markets is crucial. Choosing markets that show promise of a steady amount of sales along with an equitable amount of stability with the rate of exchange between the two currencies involved will aid in keeping the risk within reason and position the business to benefit from the operation of those international facilities.