This document discusses two types of corporate exposure to foreign exchange risk: accounting exposure and economic exposure. Accounting exposure results from foreign currency transactions and translations recorded on a company's balance sheet. It includes transaction exposure from purchases/sales in foreign currency and translation exposure from converting foreign assets/liabilities to the reporting currency. Economic exposure measures how unexpected currency fluctuations could impact a company's future cash flows and value. It is the most important type of exposure for investors. The document outlines steps to measure economic exposure, including identifying operating exposures from international activities, and creating strategies to manage risk based on factors like pricing flexibility and demand elasticity.
2. THE CONCEPT OF EXPOSURE
⚫Introduction
⚫Accounting exposure
⚫Economic exposure
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3. INTRODUCTION
⚫Exposure is the extent to which you
face foreign exchange risk
⚫There are two general types of
exposure:
⚪ Accounting exposure
⚪ Economic exposure
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4. ACCOUNTING EXPOSURE
⚫Accounting exposure is the exchange
rate exposure that results when
consolidated financial statements are
prepared in a single currency
⚫Two types of accounting exposure:
⚪ Transaction exposure
⚪ Translation exposure
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5. ACCOUNTING EXPOSURE
(CONT’D)
⚫Transaction exposure results from
transactions involving the purchase or
sale of goods or services with the price
stated in foreign currency
⚪ Exists until the payable or receivable is
liquidated
⚪ E.g., a U.S. importer must pay a Indian
supplier in Bangaluru.
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7. ECONOMIC EXPOSURE
⚫Economic exposure measures the risk
that the value of a security or a firm
will decline due to an unexpected
change in relative foreign exchange
rates
⚪ Would reduce the value of the security or firm
⚪ The most important type of exposure for
security investors
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9. Steps to the Creation of an
Economic Exposure Strategy
Step 1. Identifying the exposure
Step 2. Define the risk
Step 3. List the operating exposures
Step 4. Measuring economic exposure
Step 5. Guidelines to create strategy
Step 6. Methods to manage risk
10. IDENTIFYING FOREIGN EXCHANGE
RISK AND ECONOMIC EXPOSURE
I. FOREIGN EXCHANGE RISK:
Step I.
A.Economic exposure defined:
focuses on the future impact of unexpected currency fluctuations
on firm’s value.
1 .The most important aspect of foreign exchange risk
management:
Incorporate expectations about the risk into all basic
decisions of the firm.
11. Step 2. Define the risk
2. Definition:
Economic exposure =Transaction exposure +
Operating exposure: arises because currency
fluctuations alter a company’s future revenues and
expenses.
12. FOREIGN EXCHANGE RISK AND ECONOMIC
EXPOSURE
B. Real Exchange Rates Changes and Risk
Nominal v. real exchange rates: real rate has
been adjusted for price changes.
Assume: no two nations have the same annual rate
of inflation.
13. FOREIGN EXCHANGE RISK AND ECONOMIC
EXPOSURE
C. Implications:
1. If nominal rates change with an
equal price change, no alteration to cash flows.
2. If real rates change, it causes relative price
changes and changes in purchasing power.
⚫
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FOREIGN EXCHANGE RISK AND ECONOMIC
EXPOSURE
Operating Exposure begins:
the moment a firm starts to invest in a market
subject to foreign competition or in sourcing goods
or inputs abroad.
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Step 3 List the new risks
Operating exposure begins with
New product development
A distribution network
Brand name development
Marketing to foreign markets
Foreign supply contracts
Overseas production facilities
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Step 4. Measuring economic exposure
To measure operating exposure requires a longer-
term perspective. i.e. Cost and price
competitiveness could be affected by unexpected
exchange rate changes.
17. FOREIGN EXCHANGE RISK AND ECONOMIC
EXPOSURE
A decline in the real value of a currency:
makes exports and import-competing goods more competitive
An appreciating currency makes:
imports and export-competing goods more competitive
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FOREIGN EXCHANGE RISK AND
ECONOMIC EXPOSURE
During an appreciation of home currencies:
Exporters face two choices:
keep prices constant (but lose sales)
or
adjust prices to foreign currency to maintain
market share (lose profits).
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Step 5. Guidelines to create a
strategy
I. ECONOMIC CONSEQUENCES
The impact on Operating Exposure of a real rate
change depends upon: Pricing flexibility and
1. Price elasticity of demand
2. Degree of product differentiation
3. The Ability to shift production
and the substitution of inputs
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FOREIGN EXCHANGE RISK AND ECONOMIC
EXPOSURE
SUMMARY
a. the economic impact of a currency change
depends on the offset by the difference in inflation rates or
the change in real exchange rates.
b. It is the relative price changes that ultimately
determine a firm’s long-run exposure.