Exchange rate fluctuations affect not only multinationals and large corporations, but also small and medium-sized enterprises. Therefore, understanding and managing exchange rate risk is an important subject for business owners and investors.
There are various kinds of exposure and related techniques for measuring the exposure. Of all the exposures, economic exposure is the most important one and it can be calculated statistically.
Companies resort to various strategies to contain economic exposure.
Companies are exposed to three types of risk caused by currency volatility −
Transaction exposure − Exchange rate fluctuations have an effect on a company’s obligations to make or receive payments denominated in foreign currency in future. Transaction exposure arises from this effect and it is short-term to medium-term in nature.
Translation exposure − Currency fluctuations have an effect on a company’s consolidated financial statements, particularly when it has foreign subsidiaries. Translation exposure arises due to this effect. It is medium-term to long-term in nature.
Economic (or operating) exposure − Economic exposure arises due to the effect of unpredicted currency rate fluctuations on the company’s future cash flows and market value. Unanticipated exchange rate fluctuations can have a huge effect on a company’s competitive position.
Note that economic exposure is impossible to predict, while transaction and translation exposure can be estimated.
Consider a big U.S. multinational with operations in numerous countries around the world. The company’s biggest export markets are Europe and Japan, which together offer 40% of the company’s annual revenues.
The company’s management had factored in an average slump of 3% for the dollar against the Euro and Japanese Yen for the running and the next two years. The management expected that the Dollar will be bearish due to the recurring U.S. budget deadlock, and growing fiscal and current account deficits, which they expected would affect the exchange rate.
However, the rapidly improving U.S. economy has triggered speculation that the Fed will tighten monetary policy very soon. The Dollar is rallying, and in the last few months, it has gained about 5% against the Euro and the Yen. The outlook suggests further gains, as the monetary policy in Japan is stimulative and the European economy is coming out of recession.
The U.S. company is now facing not just transaction exposure (as its large export sales) and translation exposure (as it has subsidiaries worldwide), but also economic exposure. The Dollar was expected to decline about 3% annually against the Euro and the Yen, but it has already gained 5% versus these currencies, which is a variance of 8 percentage points at hand. This will have a negative effect on sales and cash flows. The investors have already taken into account the currency fluctuations and the stock of the company fell 7%.
Foreign asset or overseas cash flow value fluctuates with the exchange rate changes. We know from statistics that a regression analysis of the asset value (P) versus the spot exchange rate (S) will offer the following regression equation −
P = a + (b x S) + e
Where, a is the regression constant, b is the regression coefficient, and e is a random error term with a mean of zero. Here, b is a measure of economic exposure, and it measures the sensitivity of an asset’s dollar value to the exchange rate.
The regression coefficient is the ratio of the covariance between the asset value and the exchange rate, to the variance of the spot rate. It is expressed as −
Economic Exposure – Numerical Example
A U.S. company (let us call it USX) has a 10% stake in a European company – say EuroStar. USX is concerned about a decline in the Euro, and as it wants to maximize the Dollar value of EuroStar. It would like to estimate its economic exposure.
USX thinks the probabilities of a stronger and/or weaker Euro is equal, i.e., 50–50. In the strong-Euro scenario, the Euro will be at 1.50 against the Dollar, which would have a negative impact on EuroStar (due to export loss). Then, EuroStar will have a market value of EUR 800 million, valuing USX’s 10% stake at EUR 80 million (or $120 million).
In the weak-Euro scenario, currency will be at 1.25; EuroStar would have a market value of EUR 1.2 billion, valuing USX’s 10% stake will be equal to $150 million.
If P represents the value of USX’s 10% stake in EuroStar in Dollar terms, and S represents the Euro spot rate, then the covariance of P and S is −
Cov (P,S) = –1.875
Var (S) = 0.015625
Therefore, b = –1.875 ÷ (0.015625) = – EUR 120 million
USX’s economic exposure is a negative EUR 120 million, which is equivalent to saying that the value of its stake in EuroStar decreases as the Euro gets stronger, and increases as the Euro weakens.
The economic exposure is usually determined by two factors −
Whether the markets where the company inputs and sells its products are competitive or monopolistic? Economic exposure is more when either a firm’s input costs or goods’ prices are related to currency fluctuations. If both costs and prices are relative or secluded to currency fluctuations, the effects are cancelled by each other and it reduces the economic exposure.
Whether a firm can adjust to markets, its product mix, and the source of inputs in a reply to currency fluctuations? Flexibility would mean lesser operating exposure, while sternness would mean a greater operating exposure.
The economic exposure risks can be removed through operational strategies or currency risk mitigation strategies.
Diversifying production facilities and markets for products − Diversification mitigates the risk related with production facilities or sales being concentrated in one or two markets. However, the drawback is the company may lose economies of scale.
Sourcing flexibility − Having sourcing flexibilities for key inputs makes strategic sense, as exchange rate moves may make inputs too expensive from one region.
Diversifying financing − Having different capital markets gives a company the flexibility to raise capital in the market with the cheapest cost.
The most common strategies are −
Matching currency flows − Here, foreign currency inflows and outflows are matched. For example, if a U.S. company having inflows in Euros is looking to raise debt, it must borrow in Euros.
Currency risk-sharing agreements − It is a sales or purchase contract of two parties where they agree to share the currency fluctuation risk. Price adjustment is made in this, so that the base price of the transaction is adjusted.
Back-to-back loans − Also called as credit swap, in this arrangement, two companies of two nations borrow each other’s currency for a defined period. The back-to-back loan stays as both an asset and a liability on their balance sheets.
Currency swaps − It is similar to a back-to-back loan, but it does not appear on the balance sheet. Here, two firms borrow in the markets and currencies so that each can have the best rates, and then they swap the proceeds.