Foreign Exchange Risk and Economic Exposure
The most important aspect of foreign exchange risk management is to incorporate currency change expectations into all basic corporate decisions. In performing this task, the firm must know what is at risk. However, there is a major discrepancy between accounting practice and economic reality in terms of measuring exposure, which is the degree to which a company is affected by exchange rate changes.
As we saw in Chapter 10, those who use an accounting definition of exposure—whether FASB-52 or some other method—divide the balance sheet’s assets and liabilities into those accounts that will be affected by exchange rate changes and those that will not. In contrast, economic theory focuses on the impact of an exchange rate change on future cash flows. That is, economic exposure is based on the extent to which the value of the firm—as measured by the present value (PV) of its expected future cash flows—will change when exchange rates change.
Specifically, if PV is the present value of a firm, then that firm is exposed to currency risk if APV/Ae is not equal to zero, where APV is the change in the firm’s present value associated with an exchange rate change, Δe. Exchange risk, in turn, is defined as the variability in the firm’s value that is caused by uncertain exchange rate changes. Thus, exchange risk is viewed as the possibility that currency fluctuations can alter the expected amounts or variability of the firm’s future cash flows.
Economic exposure can be separated into two components: transaction exposure and operating exposure. We saw that transaction exposure stems from exchange gains or losses on foreign-currency-denominated contractual obligations. Although transaction exposure is often included under accounting exposure, as it was in Chapter 10, it is more properly a cash-flow exposure and, hence, part of economic exposure. However, even if the company prices all contracts in dollars or otherwise hedges its transaction exposure, the residual exposure—longer-term operating exposure—still remains.
Operating exposure arises because currency fluctuations can alter a company’s future revenues and costs—that is, its operating cash flows. Consequently, measuring a firm’s operating exposure requires a longer-term perspective, viewing the firm as an ongoing concern with operations whose cost and price competitiveness could be affected by exchange rate changes.
Thus, the firm faces operating exposure the moment it invests in servicing a market subject to foreign competition or in sourcing goods or inputs abroad. This investment includes new-product development, a distribution network, foreign supply contracts, or production facilities. Transaction exposure arises later on and only if the company’s commitments lead it to engage in foreign-currency-denominated sales or purchases. Exhibit 11.1 shows the time pattern of economic exposure.