Foreign Exchange Exposure

Following up on my article about International Business Risks I want to go into more detail about Foreign Exchange Exposure.  Most people are familiar with foreign exchange fluctuations but there are several different types of currency exposure, and some types are more serious than other types.  Below I will cover the following topics:  

• Translation Exposure
• Transaction Exposure
• Economic Exposure
• Hedging?  A solution or not 

Translation Exposure, in my opinion, may not be that serious and may not be “real”.  Translation exposure is defined as the value of a company’s foreign earnings and assets when reporting consolidated financial statements.  For example, if a US firm has business in a foreign country and the currency in that country devalues then when reporting their US financial statements the value of that foreign business reduces in US Dollars terms.  

Many people argue that translation exposure is not real, that it is just a reporting or accounting exercise.  The revenue, expenses and assets in the foreign business remain constant in local currency so based on my experience I tend to agree.  However, there is another argument that when shareholders and other investors see the consolidated financial statements it gives the impression that the overseas part of the business is suffering and that can affect the company’s stock price.  It is not real but it can affect the opinions or emotions of investors if not well explained or understood.

Transaction Exposure on the other hand is very real.  This is defined as a currency conversion or transaction.  That is, for example, transferring foreign earnings back to a company’s head office.  Or buying an asset in one currency and selling it in another currency.  The change in exchange rates directly affects the value one receives in another currency.  The types of companies that have significant risk are ones that have global assets in one currency but revenues in other currencies. This is very typical of airlines or other transportation companies that purchase assets (their ships) financed in US dollars but receive revenue in local currency from each port of origin.  If you recall my article on Maturity (Revenue) Mismatch, having foreign currencies in your revenue portfolio adds an extra element of complexity to managing revenue mismatch.  Now, managing the time horizon of your assets and liabilities is complicated by fluctuating exchange rates between those assets and liabilities.  

To be clear, I am absolutely for companies expanding their business in other countries.  It is a great opportunity to grow revenue and market share but I just want to outline some of the additional complexities that go along with international expansion.  In my experience, many companies do not understand this until they get caught up in the dynamics of it. 

Economic Exposure has been defined as long-term exposure whereas transaction exposure is short-term.  That is probably a fair statement but the economist in me wants to define it in more detail.  Economic exposure occurs when currencies fluctuate over time and goods or services become more or less expensive with international trade.  Buyers will adapt and shift purchases of foreign goods to lower-cost countries.

Recall the Asian financial crisis in 1997 when many countries experienced currency devaluations of up to 50 percent.  In the short-term these countries went into financial recession.  However, by 1998 exports from these countries grew dramatically and that helped to pull these countries out of recession and into an economic boom because of their relatively lower cost structure.  The opposite is also true with countries that have seen currencies strengthen resulting in businesses and manufacturing moving to lower-cost countries.  This is how currency fluctuations affect the economic exposure of a country and international businesses.

Hedging.  Many people have suggested that the way to protect your business from foreign exchange risk is to hedge your business with foreign currencies, currency swaps, currency futures, or a combination of those hedging techniques.  Honestly, I am not in favor of recommending those hedging techniques across all industries, and it is expensive.  I believe hedging has its place in the financial markets but may not be as useful in the physical world, meaning international trade.  I believe “natural hedging” is much better by using pricing and cash flow analysis to protect an international business.

In my next article I will discuss the impacts of international cash flows, pricing and natural hedges.