Transaction Exposure
Transaction exposure arises out of the various types of transactions that require settlement in a foreign currency. Examples are cross-border trade, borrowing and lending in foreign currencies, and the local purchasing and sales activities of foreign subsidiaries. Strictly speaking, of course, the items already on a firm’s balance sheet, such as loans and receivables, capture some of these transactions. However, a detailed transaction exposure report must also contain a number of off-balance sheet items as well, including future sales and purchases, lease payments, forward contracts, loan repayments, and other contractual or anticipated foreign currency receipts and disbursements.
In terms of measuring economic exposure, however, a transaction exposure report, no matter how detailed, has a fundamental flaw: the assumption that local currency cost and revenue streams remain constant following an exchange rate change.
That assumption does not permit an evaluation of the typical adjustments that consumers and firms can be expected to undertake under conditions of currency change. Hence, attempting to measure the likely exchange gain or loss by simply multiplying the projected predevaluation (prerevaluation) local currency cash flows by the forecast devaluation (revaluation) percentage will lead to misleading results. Given the close relationship between nominal exchange rate changes and inflation as expressed in purchasing power parity, measuring exposure to a currency change without reference to the accompanying inflation is also a misguided task.
We will now take a closer look at the typical demand and cost effects that result from a real exchange rate change and show how these effects combine to determine a firm’s true operating exposure. In general, an appreciating real exchange rate can be expected to have the opposite effects. The dollar is assumed to be the home currency (HC).