Foreign Exchange exposure is a measure of the potential for a firm’s profitability, net cash flow and market value to change because of a change in exchange rates. An important task of the financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow and market value of the firm.
The three main types of foreign exchange exposures are accounting exposure, transaction exposure, and operating exposure
It is also called translation exposure. It is the potential for accounting derived changes in owner’s equity to occur because of the need to translate foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements.
Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. Thus it deals with changes in cash flows that result from existing contractual obligations.
This is also called economic exposure, competitive exposure or strategic exposure. It measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates. The change in value depends on the effect of the exchange rate change on future sales volume, prices and costs.
Transaction versus operating exposures
Transaction exposure and operating exposure exist because of unexpected changes in future cash flows. The difference between the two is that transaction exposure is concerned with future cash flows already contracted for, while operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness.
Measurement of transaction exposure
Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. Transaction exposure arises from
– Purchasing or selling on credit goods or services when prices are stated in foreign currency
– Borrowing or lending funds when repayment is to be made in foreign currency
– Being a party to an unperformed foreign exchange forward contract and
– Otherwise acquiring assets or incurring liabilities denominated in foreign currencies
The most common example of transaction exposure arises when a firm has receivable or payable denominated in foreign currency.
Life span of a transaction exposure
The total transaction exposure consists of quotation, backlog and billing exposures.
A transaction exposure is actually created at the first moment the seller quotes a price in foreign currency terms to a potential buyer. The quote can be either verbal, as in a telephone quote, or in the form of a written bid or even a printed price list. With the placing of an order, the potential exposure is created at the time of the quotation is converted into actual exposure, called backlog exposure because the product has not yet been shipped or billed. Backlog exposure lasts until the goods are shipped and billed, at which time it becomes billing exposure. Billing exposure remains until actual payment is received by the seller.
Transaction exposures exist before they are actually booked as foreign currency denominated receivables and payables. However many firms do not allow the hedging of quotation exposure or backlog exposure as a matter of policy. The reasoning is straightforward. Until the transaction exists on the accounting books of the firm, the probability of the exposure actually occurring is considered to be less than 100%. Conservative hedging policies dictate that contractual hedges be placed only on existing exposures.
An increasing number of firms however are actively hedging not only backlog exposures, but also selectively hedging quotation and anticipated exposures. Anticipated exposures are transactions for which there are – at present – no contracts or agreements between parties but which are anticipated on the basis of historical trends and continuing business relationships. Although on the surface this would appear to be overly speculative behaviour on the part of these firms, it may be that hedging expected foreign currency payables and receivables for future periods is the most conservative approach to protect the firm’s future operating revenues against unexpected exchange rate changes.
Measurement of operating exposure
Measuring the operating exposure of a firm requires forecasting and analysing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide.
From a broader perspective operating exposure is not just the sensitivity of a firm’s future cash flows to unexpected changes in foreign exchange rates, but also its sensitivity to other key macroeconomic variables. This factor has been labelled macroeconomic uncertainty – the parity relationships among exchange rates, interest rates and inflation rates. However, these variables are often in disequilibrium with one another. Therefore unexpected changes in interest rates and inflation rates could also have a simultaneous but differential impact on future cash flows
Measurement of accounting exposure
Two basic methods for the translation of foreign subsidiary financial statements are employed: current rate method and the temporal method. Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statements are re measured but also designate where any imbalance is to be recorded.
The current rate method is the most prevalent in the world today. Under this all financial statement line items are translated at the current exchange rate with few exceptions. The biggest advantage of the current method is that gain or loss on translation does not pass through the income statement but goes directly to a reserve account.
Under the temporal method specific assets and liabilities are translated at exchange rate consistent with the timing of the item’s creation. Under the temporal method gains or losses resulting from re measurement are carried directly to current consolidated income and not to equity reserves. Hence foreign exchange gains or losses arising from translation process do introduce volatility to consolidated current earnings.