Economic Exposure of Foreign Exchange Risk

Economic exposure is concerned with the present value of future operating cash flows to be generated by a company’s activities and how this present value, expressed in parent currency, changes following the foreign exchange rate movements. The concept of economic exposure of foreign exchange risk is most frequently applied to a company’s expected operating cash flows from foreign operations, but it can equally well be applied to a firm’s home territory operations and the extent to which the present value of those operations alters resultant upon changed exchange rates. For the purpose of convenience, the exposition that follows is based on a firm’s foreign operations.

Some experts classify transaction exposure as a subset of economic exposure. They take this view arguing that the present value of an uncovered foreign currency denominated receivable or payable will vary as exchange rates vary. Whilst we accept the logic of this view, in this article we prefer to treat economic and transaction exposures separately. This perspective is adopted because of the different levels of difficulty with which the multinational can monitor and control transaction and economic exposures.

The value of an overseas operation can be expressed as the present value of expected future operating cash flows, which are incremental to that overseas activity discounted at the appropriate discount rate.

Devaluation will affect cash inflows and cash outflows. Consider a company which is competing in the export markets. Whilst devaluation will not affect the total market size, it should have a favorable market share effect. The company in the devaluing country should increase sales or profit margins – in short it should benefit. Similarly, companies competing with imports in the domestic market should also gain since devaluation will tend to make imported products more expensive in local currency terms. However, this benefit may be offset to some extent by domestic deflation, which frequently accompanies devaluation. So, in the import competing sector of the domestic market, there will be beneficial and negative impacts. Next, in the purely domestic market, devaluation may lead to reduced company performance in the short term as a result of deflationary measures at home which so often accompany currency depreciation.

All of the above factors affect cash inflows. Devaluations also affect cash outflows. Imported inputs become more expensive. If devaluation is accompanied by domestic deflation it will probably be the case that suppliers’ prices will rise as their financing costs move up. An inverse line of reasoning applies with respect to revaluation of currency.

Getting to grips with economic exposure involves us in analyzing the effects of changing exchange rates on the following items:

  1. Export sales, where margins and cash flows should change because of devaluation should make exports more competitive.
  2. Domestic sales, where margins and cash flows should alter substantially in the import competing sector.
  3. Pure domestic sales, where the margins and cash flows should change in response to
    deflationary measure which frequently accompany devaluations.
  4. Costs of imported inputs, which should rise in response to devaluations.
  5. Cost of domestic inputs, which may vary with exchange rate changes.

The analysis is clearly complex, but it is necessary in order to assess fully how the home currency present value of overseas operations is likely to alter in response to movements in foreign exchange rates.

So far it has been assumed that the parent’s present value of its foreign subsidiary is a function of the subsidiary’s estimated future net cash flows. In other words, there is an assumption that all cash flows are distributable to the parent. In fact, host governments frequently restrict distribution to foreign parents by exchange controls.

The reader should always bear in mind that economic exposure is equally applicable to the home operations of a firm in as much as a change in exchange rates is likely to affect the present value of its home operations; this may arise for all of the reasons which would impinge upon foreign businesses.

There is another, related dimension to economic exposure. A British firm exporting goods to the USA, denominated in dollars, in competition with a West German manufacturer will be facing a transaction exposure against the dollar and an economic exposure against the Euro. Clearly, as the exchange rate between the pound and the Euro changes, the British manufacturer will be in a stronger or weaker position and this will filter through to sales levels, profit and cash generation. As such, the present value of the British company’s export business will alter as the exchange rates change. Just like the previous kind of economic exposure, this subset is difficult to quantify for reasons similar to those mentioned before.

It can be seen that assessing the economic exposure necessarily involves us in a substantial amount of work on the elasticity of demand and the behavior of costs in response to changes in exchange rates. But the critical question that one should ask is whether economic exposure (or transaction exposure or translation exposure for that matter) is of any relevance to the financial manager of an international company.

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