What’s it: Economic exposure is the variation in a company’s economic or market value due to changes in exchange rates. Currency fluctuations have an impact on the company’s financial stability. When a company invests or operates in more than one country, changes in exchange rates expose their cash flows, revenues, and profits. Economic exposure can have an enormous impact on a company’s market value because it has a long-term effect.
To mitigate this, companies can hedge. Or, they diversify their market sources to generate sales in different currencies.
Differences in economic exposure, translation exposure, and transaction exposure
Foreign exchange exposure falls into three types:
- Transaction exposure
- Translational exposure
- Economic exposure
As the name suggests, transaction exposure is concerned with the effect of changes in exchange rates on transactions’ value. Say, a domestic company buys on account a capital item from abroad and signs a purchase contract. The foreign company requires three monthly installments. When paying installments in foreign currency, domestic companies may pay more because the domestic currency depreciates.
Meanwhile, transaction exposure relates to financial reporting and accounting representations. When companies have assets or liabilities denominated in foreign currency, they must convert them into domestic currency, the currency on which financial reporting is based. Management usually pays less attention to these exposures because they continue to fluctuate in line with exchange rate movements. It is sometimes detrimental, and at other times, it is beneficial.
Furthermore, economic exposure is the most concern of management than the other two exposures. Changes in exchange rates affect firm value because they affect assets and operating cash flows.
How economic exposure works
To understand this concept, I will take a simple example.
An Indonesia company gets about 60% of its revenue from the United States market. Management assumes a gradual depreciation of the rupiah against the US dollar, say 1.5% per annum, into its operating forecast for the next two years.
Depreciation means the company’s products will be cheaper in the United States market. Therefore, the company is targeting high sales growth, say 15% per year for two years. To support increased sales, the company increased production and has purchased new machines. The company has taken a 5-year loan from a domestic bank to finance the investment.
Say, the exchange rate assumption misses. The rupiah against the US dollar actually strengthens during these two years. Sales fall 15% as appreciation made product prices more expensive in the US market.
Appreciation causes a company’s cash flow problems. Because 60% of revenue comes from the United States, the company collects a lower US dollar from sales. The appreciation also makes the conversion of US dollar sales into rupiah less.
Simultaneously, in its liabilities, the company has to pay regular loans from the bank. Ultimately, appreciation hurts a company’s profitability and cash flow. As cash flow worsens, it causes the company’s valuation to fall.
Determinants of economic exposure
The level of economic exposure is positively correlated with currency fluctuations. The higher the foreign exchange volatility, the higher the economic uncertainty and exposure. Vice versa, economic exposure decreases when foreign exchange volatility is low.
Thus, compared to domestic companies, multinational companies have greater economic exposure because most of their transactions involve several foreign currencies. Likewise, export-oriented companies also have higher exposure than local-orientated companies.
Unlike transaction exposure and translation exposure, economic exposure is difficult to measure with accuracy. Therefore, hedging against risks is also more challenging.
Economic exposure mitigation strategies
Companies mitigate economic exposure through:
- Operational strategy
- Currency risk mitigation strategy.
The operational strategy involves diversifying production facilities, sources of financing, and end product markets. In this way, the effects of changes in exchange rates can offset each other to some degree if several different currencies are involved.
- Diversification of supply and operations. For raw materials, for example, companies should have alternative suppliers to source raw materials from abroad. Suppose the raw materials’ price from the leading supplier becomes more expensive due to the exchange rate depreciation. In that case, they can switch to alternative suppliers. The same is true for production facilities.
- Access financing in different currencies. For example, companies borrow in the main currency that is the source of their revenue. Thus, the effect of currency fluctuations on revenue partially offsets the effect on interest payments.
- Diversification of sources of revenue. If the company sells products in several countries, they get different currencies. It reduces risk exposure in one particular currency.
The currency risk mitigation strategy has several alternatives. The company matches cash outflows and cash inflows with the same currency. For example, suppose an Indonesian company has significant revenue in US dollars. In that case, it should compensate for this by borrowing in US dollars. If the rupiah appreciates, sales will weaken due to higher prices in the US market. On the other hand, interest on loans in US dollars is also lower.
Next, companies can take currency swaps and effectively borrow each other’s currencies over some time.