Exchange Rate Risk: Economic Exposure by investopedia
In the present era of increasing globalization and heightened currency volatility, changes in exchange rates have a substantial influence on companies’ operations and profitability. Exchange rate volatility affects not just multinationals and large corporations, but small and medium-sized enterprises as well, even those who only operate in their home country. While understanding and managing exchange rate risk is a subject of obvious importance to business owners, investors should be familiar with it as well because of the huge impact it can have on their investments.
Economic or Operating Exposure
Companies are exposed to three types of risk caused by currency volatility:
- Transaction exposure – This arises from the effect that exchange rate fluctuations have on a company’s obligations to make or receive payments denominated in foreign currency in future. This type of exposure is short-term to medium-term in nature.
- Translation exposure – This exposure arises from the effect of currency fluctuations on a company’s consolidated financial statements, particularly when it has foreign subsidiaries. This type of exposure is medium-term to long-term.
- Economic (or operating) exposure – This is lesser known than the previous two, but is a significant risk nevertheless. It is caused by the effect of unexpected currency fluctuations on a company’s future cash flows and market value, and is long-term in nature. The impact can be substantial, as unanticipated exchange rate changes can greatly affect a company’s competitive position, even if it does not operate or sell overseas. For example, a U.S. furniture manufacturer who only sells locally still has to contend with imports from Asia and Europe, which may get cheaper and thus more competitive if the dollar strengthens markedly.
Note that economic exposure deals with unexpected changes in exchange rates – which by definition are impossible to predict – since a company’s management base their budgets and forecasts on certain exchange rate assumptions, which represents their expected change in currency rates. In addition, while transaction and translation exposure can be accurately estimated and therefore hedged, economic exposure is difficult to quantify precisely and as a result is challenging to hedge.
An example of economic exposure
Here’s a hypothetical example of economic exposure. Consider a large U.S. pharmaceutical with subsidiaries and operations in a number of countries around the world. The company’s largest export markets are Europe and Japan, which together account for 40% of its annual revenues. Management had factored in an average decline of 3% for the dollar versus the euro and Japanese yen for the current year and next two years. Their bearish view on the dollar was based on issues such as the recurring U.S. budget deadlock, as well as the nation’s growing fiscal and current account deficits, which they expected would weigh on the greenback going forward.
However, a rapidly improving U.S. economy has triggered speculation that the Federal Reserve may be poised to tighten monetary policy much sooner than expected. The dollar has been rallying as a result, and over the past few months, has gained about 5% against the euro and yen. The outlook for the next two years suggests further gains in store for the dollar, as monetary policy in Japan remains very stimulative and the European economy is just emerging out of recession.
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