Firms doing business in more than one currency (i.e., U.S. dollar, euro, yen, etc.) face currency exposure. This exposure arises from the fact that, in the current global environment of floating exchange rates, the value of a currency relative to other currencies (its exchange rate) is constantly changing—rising or falling based on forces of supply and demand, government activity, even currency speculators. There are three main types of currency exposure—transaction, translation, and economic.
Transaction exposure reflects the exposure of the firm to changes in the value of a foreign-currency denominated transaction (sale or purchase) between when the price is set and when payment is made. For example, say a U.S. aircraft manufacturer contracts to produce and sell 10 airplanes to a German airline for 100 million euros, to be paid upon delivery in six months. Although the dollar/euro exchange rate when the deal is signed is $1.50/euro, the U.S. manufacturer does not know whether the value of the 100 million euros it will receive in six months will be higher or lower than the current value of $150 million (dollars), and is thus faced with transaction exposure. If the dollar/euro exchange rate drops to $1.25/euro in six months, the 100 million euros will be worth only $125 million, whereas a rise to $1.75/euro would result in a better-than-expected $175 million. If the U.S. firm wishes to eliminate variability in the dollar amount, they may enter into a contract on the forward market, which allows them to lock in a future exchange rate. Alternatively, they may purchase a foreign currency option, insuring them against the downside risk of a decline in the value of the euros they will be receiving, while still allowing them to benefit from potential increase in the euro’s value.
Translation exposure arises within the firm’s accounting function. The financial statements of the firm’s foreign units must be translated into the parent currency, then consolidated into the financial statements of the parent. If there has been a shift in the exchange rate between the subsidiary’s and parent’s currencies since the last consolidation was performed, unrealized “paper” gains/losses may affect the company’s books. If the U.S. aircraft manufacturer had purchased a German factory for 10 million euros when the exchange rate was $1.50/euro, it would appear as an asset on the parent’s books, valued at $15 million. If the exchange rate were $1.75/euro the following year, that same factory, with a value of 10 million euros (not accounting for depreciation), would translate into the parent’s books valued at $17.5 million, a $2.5 million gain based not on increasing real value, but merely driven by rising exchange rates (alternatively, a drop in the exchange rate to $1.25/euro would create a $2.5 million “paper” loss).
It can be risky for firms to make strategic decisions based on “paper” gains/losses; one technique for minimizing translation exposure is to balance foreign currency assets and liabilities. The aircraft manufacturer could borrow 10 million euros to purchase the German factory, resulting in a 10 million euro asset (the factory) and a 10 million euro liability (the loan), which would effectively cancel each other out—whenever the euro rose/fell against the dollar, asset and liability would rise/fall simultaneously.
Economic exposure reflects the degree to which exchange rate shifts affect a firm’s future foreign profitability. This exposure has the greatest potential for long-term impact on firm performance, and thus requires greater strategic planning and decision making on the part of the firm. Once the U.S. aircraft manufacturer owns a factory in Germany, economic exposure could be triggered by a large rise in the value of the euro, say from $1.50/euro to $2.00/euro. Such a shift may hurt the firm (reduced export performance from Germany, as their products will now look pricier on international markets) and/or may have a positive impact on the firm (profits made in euros will translate into more dollars than before). One way firms can manage economic exposure is to diversify production locations internationally, so that large shifts in one currency will not affect their entire business.
- Saleh Alharbi, Three Essays on Currency Exposure (University of Wisconsin, 2004);
- Naohiko Baba, Kyoji Fukao, Nihon Ginko, and Kin’yu Kenkyujo, Currency Risk Exposure of Japanese Firms with Overseas Production Bases: Theory and Evidence (Tokyo Institute for Monetary and Economic Studies, Bank of Japan, 2000);
- Soehnke M. Bartram, “What Lies Beneath: Foreign Exchange Rate Exposure, Hedging and Cash Flows,” Journal of Banking and Finance (v.32/8, 2008);
- David K. Eiteman, Michael H. Moffett, and Arthur Stonehill, Multinational Business Finance, 11th ed. (Addison-Wesley, 2007);
- Sanjoy Ghosh, Hedging Currency Exposure (University of Pennsylvania, 2000);
- Philip R. Lane and Jay C. Shambaugh, The Long or Short of It: Determinants of Foreign Currency Exposure in External Balance Sheets (Centre for Economic Policy Research, 2008);
- B. Lubach, Currency Exposure in Mutual Funds: To Hedge or Not to Hedge (Erasmus Universiteit, 2006).
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