Assignment

of
International Finance and Financial
derivatives

Topic- Economic Exposure Meaning and its

Measurement

Submitted to: Submitted by:

Dr. Anu Sahi Dikshita Jain
MBA- 4B
181212

Meaning of economic exposure

Economic exposure, also known as operating exposure refers to an effect caused
on a company’s cash flows due to unexpected currency rate fluctuations.
Economic exposures are long-term in nature and have a substantial impact on a
company’s market value.
Economic exposure can prove to be difficult to hedge as it deals with
unexpected fluctuations in foreign exchange rates. As the foreign exchange
volatility rises, the economic exposure increases and vice versa. Multinational
companies having numerous subsidiaries overseas and transactions in foreign
currencies face a greater risk of economic exposure.
Economic exposure is a type of foreign exchange exposure caused by the effect
of unexpected currency fluctuations on a company’s future cash flows, foreign
investments, and earnings. Economic exposure, also known as operating
exposure, can have a substantial impact on a company’s market value since it
has far-reaching effects and is long-term in nature. Companies can hedge
against unexpected currency fluctuations by investing in foreign exchange (FX)
trading.

Example of Economic Exposure:

Assume that a large U.S. company that gets about 50% of its revenue from
overseas markets has factored in a gradual decline of the U.S. dollar against
major global currencies—say 2% per annum—into its operating forecasts for
the next few years. If the dollar appreciates instead of weakening gradually in
the years ahead, this would represent economic exposure for the company. The
dollar’s strength means that the 50% of revenues and cash flows the company
receives from overseas will be lower when converted back into dollars, which
will have a negative effect on its profitability and valuation.

Understanding Economic Exposure

The degree of economic exposure is directly proportional to currency volatility.
Economic exposure increases as foreign exchange volatility increases and
decreases as it falls. Economic exposure is obviously greater for multinational
companies that have numerous subsidiaries overseas and a huge number of
transactions involving foreign currencies. However, increasing globalization has
made economic exposure a source of greater risk for all companies and
consumers. Economic exposure can arise for any company regardless of its size
and even if it only operates in domestic markets.

Unlike transaction exposure and translation exposure (the two other types of

currency exposure), economic exposure is difficult to measure precisely and
hence challenging to hedge. Economic exposure is also relatively difficult to
hedge because it deals with unexpected changes in foreign exchange rates,
unlike expected changes in currency rates, which form the basis for corporate
budgetary forecasts.

For example, small European manufacturers that sell only in their local markets
and do not export their products would be adversely affected by a stronger euro,
since it would make imports from other jurisdictions such as Asia and North
America cheaper and increase competition in European markets.

ECONOMIC MEASURE
Exposure measures how the value of a firm, the present value of all future cash
flows, will be affected by changes in foreign exchange rates. Management of
economic exposure is the effort to control and reduce the adverse effect of
exchange rate fluctuations on firm value. Changes or fluctuations in exchange
rates have effect on cash flows/value of firms engaged in international activities
as well as firms of domestic nature. The value of a pure domestic firm may be
affected by economic exposure through foreign competition in the domestic and
local market. Firms with more foreign costs than foreign revenues will be
unfavourably affected by stronger foreign currencies; while firms with more
foreign revenues than foreign costs will be unfavourably affected by weaker
foreign currencies. Table 14.1 describes the effects on firms’ activity of
currency appreciation/depreciation, which affect the present value of future cash
flows and firm value. Currency depreciation or appreciation is in real terms
when relevant, though depreciation or appreciation in terms of nominal
exchange rates can also be, and in many cases is, real. However, nominal
depreciation/appreciation matters where cash flows are bound by contractual
agreements. When the domestic currency appreciates, foreign goods become
cheaper and more competitive, so domestic sales of a firm may fall in the
relevant domestic market where domestic goods compete with imported foreign
goods, reducing the firm’s cash inflows. When the domestic currency
depreciates, foreign goods be-come dearer and less competitive, so domestic
sales as well as cash inflows of a firm may increase in the relevant domestic
market since domestic goods become better positioned compared w ith
imported foreign goods. A firm’s foreign sales will be affected by changes in
the relative currency value in a similar way. If the domestic currency
appreciates, goods for foreign sales denominated in the domestic currency
become more expensive in terms of the foreign currency in the foreign market
and they become less competitive. Consequently, foreign sales fall and cash
flows decline as a result of domestic currency appreciation. In contrast,
depreciation of the domestic currency makes goods for foreign sales cheaper
and more competitive and, consequently, foreign sales increase. The
competitiveness of goods for foreign sales denominated in the foreign currency
remains unchanged in the foreign market whether the domestic currency
appreciates or depreciates, so sales, as well as cash flows measured in the
foreign currency will not be affected. However, the amount of cash flows
denominated in the domestic currency will decrease as a result of domestic
currency appreciation, and will increase as a result of domestic

currency depreciation. There-fore, the effect on foreign sales of currency

appreciation/depreciation would be the same whether foreign sales are
denominated in the domestic currency or foreign currency.
 MEASURING ECONOMIC EXPOSURE

Economic exposure measures how the value of a firm, the present value of all
future cash flows, will be affected by changes in foreign exchange rates.
Management of economic exposure is the effort to control and reduce the
adverse effect of exchange rate fluctuations on firm value. Changes or
fluctuations in exchange rates have effect on cash flows/value of firms engaged
in international activities as well as firms of domestic nature. The value of a
pure domestic firm may be affected by economic exposure through foreign
competition in the domestic and local market. Firms with more foreign costs
than foreign revenues will be unfavourably affected by stronger foreign
currencies; while firms with more foreign revenues than foreign costs will be
unfavourably affected by weaker foreign currencies. the effects on firms’
activity of currency appreciation/depreciation, which affect the present value of
future cash flows and firm value. Currency depreciation or appreciation is in
real terms when relevant, though depreciation or appreciation in terms of
nominal exchange rates can also be, and in many cases is, real. However,
nominal depreciation/appreciation matters where cash flows are bound by
contractual agreements.

When the domestic currency depreciates, foreign goods become dearer and less
competitive, so domestic sales as well as cash inflows of a firm may increase in
the relevant domestic market since domestic goods become better positioned
compared with imported foreign goods. When the domestic currency
appreciates, foreign goods become cheaper and more competitive, so domestic
sales of a firm may fall in the relevant domestic market where domestic goods
compete with imported foreign goods, reducing the firm’s cash inflows. A
firm’s foreign sales will be affected by changes in the relative currency value in
a similar way. If the domestic currency appreciates, goods for foreign sales
denominated in the domestic currency become more expensive in terms of the
foreign currency in the foreign market and they become less competitive.
Consequently, foreign sales fall and cash flows decline as a result of domestic
currency appreciation. In contrast, depreciation of the domestic currency makes
goods for foreign sales cheaper . Therefore, the effect on foreign sales of
currency appreciation/depreciation would be the same whether foreign sales are
denominated in the domestic currency or foreign currency.
 DETERMINING ECONOMIC EXPOSURE

The following are the two factors that help in determining economic exposure:
 Economic exposure is higher for firms having both, product prices and
input costs sensitive to currency fluctuations. It is lower when costs and prices
are not sensitive to currency fluctuations.
 Economic exposure is higher for firms which do not adjust its markets,
product mix, and source of inputs in accordance with currency fluctuations.
Flexibility in adapting to currency rate fluctuations indicates lesser economic
exposure.
After gaining an insight on how to determine economic exposure, we will have
a look at how to manage the same
 Conclusion
An awareness of the impact of economic exposure can help firms take steps to
mitigate this risk. Investors should identify stocks and companies that have
major exposures and make better investment choices during times when
exchange rate volatility is at its peak.

Economic exposure is a type of foreign exchange exposure caused by the effect

of unexpected currency fluctuations.Exposure increases as foreign exchange
volatility increases and decreases as it falls.Can be mitigated either through
operational strategies or currency risk mitigation strategies.

Economic exposure is a type of foreign exchange exposure caused by the effect

of unexpected currency fluctuations on a company’s future cash flows, foreign
investments, and earnings. Economic exposure, also known as operating
exposure, can have a substantial impact on a company’s market value since it
has far-reaching effects and is long-term in nature. Companies can hedge
against unexpected currency fluctuations by investing in foreign exchange (FX)
trading.