19. TRANSACTION AND ECONOMIC EXPOSURES
As a business invests or operates in a foreign country, a changing exchange rate causes
gains or losses on international business activities. We define these gains or losses as transaction
exposure, economic exposure, translation exposure, and tax exposure. Consequently, this
chapter defines the types of exposures and outlines the strategies an international company can
use to reduce its losses from the transaction and economic exposures. Unfortunately, the
translation and tax exposures are beyond the scope of this book.
Exposure Types
Firms are subjected to currency risk, called exposure. Exposure changes a company's
profits, net cash flow, and market value. Every international corporation or business can
experience four exposures, originating from their international activities. We explain each
exposure in detail.
Transaction exposure comes from the risk of transactions denominated in different
currencies. Consequently, a change in an exchange rate alters the value of outstanding financial
obligations, such as accounts receivable and accounts payable. Unfortunately, a change in an
exchange rate impacts cash flow and alters a company's current contractual obligations. For
example, Swiss Cruises, a Swiss company, buys U.S. supplies and sells cruises to U.S.
customers. Hence, it prices its supplies and vacation cruises in U.S. dollars. Any fluctuations in
the U.S. dollar-Swiss franc exchange rate will alter its financial obligations.
Economic exposure is how a firm’s expected cash flows are affected by unexpected
changes in currency exchange rates. Exchange rate alters future sales, prices, and costs. We also
call it operating exposure, competitive exposure, or strategic exposure. For example, Swiss
Cruises pays most its costs in francs and receives 50% of its revenues in U.S. dollars.
Unfortunately, Swiss Cruises cannot raise its price because vacation cruises are highly
competitive, and it would lose customers by raising the price. If the Swiss franc is appreciating
while the U.S. dollar is depreciating, subsequently, its cash flows will worsen. Unfortunately, its
revenues are in U.S. dollars that are losing value while its costs are in francs that are
strengthening in value. Keeping them straight, economic exposure is how a change in an
exchange rate influences a company's finances over time, while transaction exposure is a change
in exchange rates impact current assets and liabilities.
Translation exposure, referred to as accounting exposure, is fluctuations in currency
exchange rates affect a firm’s consolidated statements. For example, Swiss Cruises has
inventories of U.S. dollars and U.S. dollar loans of an equal amount. Then accountants convert
balance sheet items into francs. A depreciating U.S. dollar causes the value of loans to decrease
because its liabilities are decreasing. However, the value of current assets is decreasing from the
dollar inventories. Nevertheless, due to Swiss accounting rules, accountants use different
exchange rates to convert U.S. dollar inventories and the U.S. dollar loans into francs.
Consequently, accountants generate accounting gains or losses by using the various exchange