Exchange Rate Risk: Economic Exposure

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 holdings.

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. 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 bases their budgets and forecasts on certain 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.

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.

The U.S. pharmaceutical company is faced not just with transaction exposure (because of its large export sales) and translation exposure (as it has subsidiaries worldwide), but also with economic exposure. Recall that management had expected the dollar to decline about 3% annually against the euro and yen over a three-year period, but the greenback has already gained 5% versus these currencies, a variance of eight percentage points and growing. This will obviously have a negative effect on the company’s sales and cash flows. Savvy investors have already cottoned on to the challenges facing the company due to these currency fluctuations and the stock has declined 7% in recent months.

The value of a foreign asset or overseas cash flow fluctuates as the exchange rate changes. From your Statistics 101 class, you would know that a regression analysis of the asset value (P) versus the spot exchange rate (S) should produce the following regression equation:

$\begin{aligned} &\text{Asset Value }(P) = a + (b x S) + e\\ &\textbf{where:}\\ &a = \text{regression constant}\\ &b = \text{regression coefficient}\\ &S = \text{spot exchange rate}\\ &e = \text{random error term with mean of zero} \end{aligned}$​Asset Value (P)=a+(bxS)+ewhere:a=regression constantb=regression coefficientS=spot exchange rate​

The regression coefficient b is a measure of economic exposure, and measures the sensitivity of the asset’s dollar value to the exchange rate.

The regression coefficient is defined as the ratio of the covariance between the asset value and the exchange rate, to the variance of the spot rate. Mathematically it is defined as:

$b=\text{Cov}(P,S)\div\text{Var}(S)$b=Cov(P,S)÷Var(S)

A U.S. pharmaceutical – call it USMed – has a 10% stake in a fast-growing European company – let’s call it EuroMax. USMed is concerned about a potential long-term decline in the euro, and since it wants to maximize the dollar value of its EuroMax stake, would like to estimate its economic exposure.

USMed thinks the possibility of a stronger or weaker euro is even, i.e. 50-50. In the strong-euro scenario, the currency would appreciate to 1.50 against the dollar, which would have a negative impact on EuroMax (as it exports most of its products). As a result, EuroMax would have a market value of €800 million, valuing USMed’s 10% stake at €80 million (or $120 million). In the weak-euro scenario, the currency would decline to 1.25; EuroMax would have a market value of €1.2 billion, valuing USMed’s 10% stake at €120 million (or $150 million).

If P represents the value of USMed’s 10% stake in EuroMax in dollar terms, and S represents the euro spot rate, then the covariance between P and S (i.e., the way they move together) is:

$\begin{aligned} &\text{Cov} (P,S) = -1.875\\ &\text{Var} (S) = 0.015625\\ &\text{Therefore, } b = -1.875\div (0.015625) = -\euro 120\text{ million} \end{aligned}$​Cov(P,S)=−1.875Var(S)=0.015625​

USMed’s economic exposure is therefore negative €120 million, which means that the value of its stake in EuroMed goes down as the euro gets stronger, and goes up as the euro weakens.

In this example, we have used a 50-50 possibility (of a stronger or weaker euro) for the sake of simplicity. However, different probabilities can also be used, in which case the calculations would be a weighted average of these probabilities.

A company’s operating exposure is primarily determined by two factors:

• Are the markets where the company gets its inputs and sells its products competitive or monopolistic? Operating exposure is higher if either a firm’s input costs or product prices are sensitive to currency fluctuations. If both costs and prices are sensitive or not sensitive to currency fluctuations, these effects offset each other and reduce operating exposure.
• Can the firm adjust its markets, product mix and source of inputs in response to currency fluctuations? Flexibility in this case would indicate lesser operating exposure, while inflexibility would suggest greater operating exposure.

The risks of operating or economic exposure can be alleviated either through operational strategies or currency risk mitigation strategies.

• Diversifying production facilities and markets for products: Diversification would mitigate the risk inherent in having production facilities or sales concentrated in one or two markets. However, the drawback here is that the company may have to forgo economies of scale.
• Sourcing flexibility: Having alternative sources for key inputs makes strategic sense, in case exchange rate moves make inputs too expensive from one region.
• Diversifying financing: Having access to capital markets in several major nations gives a company the flexibility to raise capital in the market with the cheapest cost of funds.

The most common strategies in this regard are listed below.

• Matching currency flows: This is a simple concept that requires foreign currency inflows and outflows to be matched. For example, if a U.S. company has significant inflows in euros and is looking to raise debt, it should consider borrowing in euros.
• Currency risk-sharing agreements: This is a contractual arrangement in which the two parties involved in a sales or purchase contract agree to share the risk arising from exchange rate fluctuations. It involves a price adjustment clause, such that the base price of the transaction is adjusted if the rate fluctuates beyond a specified neutral band.
• Back-to-back loans: Also known as a credit swap, in this arrangement two companies located in different countries arrange to borrow each other’s currency for a defined period, after which the borrowed amounts are repaid. As each company makes a loan in its home currency and receives equivalent collateral in a foreign currency, a back-to-back loan appears as both an asset and a liability on its balance sheets.

An awareness of the potential impact of economic exposure can help business owners take steps to mitigate this risk. While economic exposure is a risk that is not readily apparent to investors, identifying companies and stocks that have the biggest such exposure can help them make better investment choices during times of heightened exchange rate volatility.