exchange rate exposure
exchange rate exposure
the extent of a firm's potential losses/gains on its overseas operations (measured in domestic currency terms) as a result of EXCHANGE RATE changes. The firm can be exposed to variations in exchange rates in a number of ways:- translation or accounting exposure arises when consolidating (see CONSOLIDATED ACCOUNTS) the assets, liabilities, revenues and expenses of overseas subsidiaries (expressed in foreign currencies) into the parent company's group accounts (expressed in the parent's domestic currency);
- transactions exposure arises when a firm exports and imports products and borrows funds from abroad or invests overseas. For example, when a firm exports a product, invoicing the customer in terms of the customer's own local currency, and granting the customer 60 days' credit, then the firm is exposed to the effects of exchange rate variations during the 60-day credit period, which may decrease or increase the domestic currency value of the money due. Were the exchange rate of the foreign currency to fall dramatically vis-à-vis the domestic currency, then the exchange rate loss may completely eliminate any expected profit on the transaction;
- economic or cash flow exposure is concerned with the impact of exchange rate variations on the future cash flows generated by a company's production and marketing operations. Long-term or dramatic changes in exchange rates may well force a firm to rethink its FOREIGN MARKET SERVICING STRATEGY and raw material SOURCING strategy. For instance, a firm which serviced its overseas markets by direct exporting from domestic plants might decide to establish local production units to supply these markets instead, if an exchange rate appreciation were to render its export prices uncompetitive.
There are a number of mechanisms whereby a firm can reduce its exposure to potential losses resulting from exchange rate changes. First, a firm can seek to prevent an exposed position from arising by using such internal exposure management techniques as currency matching (matching foreign currency holdings with equal foreign currency borrowings); leading and lagging (accelerating or delaying foreign currency payments and receipts where the exchange rate of the currency is expected to change); and MULTILATERAL NETTING of currency receipts and payments between subsidiaries of a MULTINATIONAL ENTERPRISE. Second, the firm can use external contractual arrangements to reduce or eliminate whatever exposure remains, hedging risks by: entering into forward exchange contracts to buy or sell currencies as appropriate (see FORWARD MARKET); FACTORING (selling the firms trade debts); buying and selling foreign exchange OPTIONS; foreign currency borrowing; the use of export credit guarantees (see EXPORT CREDIT GUARANTEE DEPARTMENT) and currency SWAPS.
exchange rate exposure
the extent of a firm's potential losses/gains on its overseas operations (measured in domestic currency terms) as a result of EXCHANGE RATE changes. The firm can be exposed to variations in exchange rates in two main ways:- transactions exposure arises when a firm exports and imports products and borrows funds from abroad or invests overseas. For example, when a firm exports a product, invoicing the customer in terms of the customer's own local currency, and granting the customer 60 days’ credit, then the firm is exposed to the effects of exchange rate variations during the 60-day credit period, which may decrease or increase the domestic currency value of the money due. Were the exchange rate of the foreign currency to fall dramatically vis-à-vis the domestic currency, then the exchange rate loss may completely eliminate any expected profit on the transactions.
- economic or cash flow exposure is concerned with the impact of exchange rate variations on the future cash flows generated by a company's production and marketing operations. Long-term or dramatic changes in exchange rate may well force a firm to rethink its FOREIGN MARKET SERVICING STRATEGY and raw material SOURCING strategy. For instance, a firm that serviced its overseas markets by direct exporting from domestic plants might decide to establish local production units to supply these markets instead, if an exchange rate appreciation were to render its export prices uncompetitive.
There are a number of mechanisms whereby a firm can reduce its exposure to potential losses resulting from exchange rate changes. First, a firm can seek to prevent an exposed position from arising by using such internal exposure management techniques as currency matching (matching foreign currency holdings with equal foreign currency borrowings); leading and lagging (accelerating or delaying foreign currency payments and receipts where the exchange rate of the currency is expected to change); and netting of currency receipts and payments between subsidiaries of a MULTINATIONAL COMPANY (offsetting receipts and payments with each other so as to leave only a single net intra-company balance to be settled in foreign currency). Second, the firm can use external contractual arrangements to reduce or eliminate whatever exposure remains, hedging risks by: entering into forward exchange contracts to buy and sell currencies as appropriate (see FUTURES MARKET); FACTORING (selling the firm's trade debts); buying and selling foreign exchange OPTIONS; foreign currency borrowing; the use of export credit guarantees (see EXPORT CREDIT GUARANTEE DEPARTMENT), SWAPS and BACK-TO-BACK LOANS.