What is Translation Risk
Translation risk is the exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. Often times, a company that does business internationally or that holds assets in a foreign country will eventually have to exchange the foreign currency back into their country of domicile's currency. If exchange rates have fluctuated a large amount, this could lead to significant changes in the value of the foreign asset or income stream. This creates risk for the company because it can sometimes be difficult to tell how much the value of currencies are going to move relative to each other. The greater the proportion of a company's assets, liabilities or equities denominated in a foreign currency, the greater the company's translation risk. Translation risk would be much more transparently titled if it were called "currency exchange risk" instead.
BREAKING DOWN Translation Risk
Translation risk poses a serious threat to companies conducting business in foreign markets. This is especially true for companies that conduct business in developing or frontier markets where the political climate is unstable and the value of the local currency is prone to fluctuation. Exchange rates can change between quarterly financial statements, causing significant variances between the reported figures from quarter to quarter. This can sometimes cause volatility in the company's stock price. Companies can attempt to minimize these risks by purchasing currency swaps or hedging through futures contracts. In addition, a company can request that clients pay for goods and services in the currency of the company's country of domicile. This way, the risk associated with local currency fluctuation is not borne by the company but instead by the client who is responsible for making the currency exchange prior to conducting business with the company.