International Finance and Accounting Handbook

6.5 MANAGING ECONOMIC EXPOSURE

(a) Economic Effects of Unanticipated Exchange Rate Changes on Cash Flows. From
this analytical framework, some practical implications emerge for the assessment of
economic exposure. First of all, the firm must project its cost and revenue streams
over a planning horizon that represents the period of time during which the firm is
“locked in,” or constrained from reacting to (unexpected) exchange rate changes. It
must then assess the impact of a deviation of the actual exchange rate from the rate
used in the projection of costs and revenues.
Subsequently, the effects on the various cash flows of the firm must be netted over
product lines and markets to account for diversification effects wherein gains and
losses could cancel out, wholly or in part. The remaining net loss or gain is the sub-
ject of economic exposure management. For a multiunit, multiproduct, multinational
corporation, the net exposure may not be very large at all because of the many off-
setting effects. By contrast, enterprises that have invested in the development of one
or two major foreign markets are typically subject to considerable fluctuations of
their net cash flows, regardless of whether they invoice in their own or in the foreign
currency.
Normally, the executives within business firms who can supply the best estimates
of these effects of unanticipated currency changes in future operating cash flows tend
to be those directly involved with purchasing, marketing, and production. Finance
managers who focus exclusively on credit and foreign exchange markets may easily
miss the essence of corporate foreign exchange risk (see Exhibit 6.6).

(b) Financial versus Operating Strategies for Hedging. When operating (cash) in-
flows and (contractual) outflows from liabilities are affected by exchange rate
changes, the general principle of prudent exchange risk management is: any effect on
cash inflows and outflows should cancel out as much as possible. This can be
achieved by maneuvering assets, liabilities, or both. Copeland and Yoshi, whose
study of currency hedging found transactions hedging to be of little value, assert,
“relocating plants and adjusting pricing often provide the best hedge against foreign
exchange risk” (Copeland and Yoshi, 1996). When should operations—the asset
side—be used?
We have demonstrated that exchange rate changes can have tremendous effects on
operating cash flows. Does it not therefore make sense to adjust operations to hedge

6 • 18 MANAGEMENT OF CORPORATE FOREIGN EXCHANGE RISK

For practical purposes, four questions capture the extent of a company's foreign exchange ex-
posure:

1. How quickly can the firm adjust prices to offset the impact of an unexpected exchange rate
   change on profit margins?


2. How quickly can the firm change sources for inputs and markets for outputs? Or, alterna-
   tively, how diversified are a company's factor and product markets?


3. To what extent does the firm have the ability to switch markets and sources quickly?


4. Do changes in the volume of sales, associated with unexpected exchange rate changes,
   have an impact on the value of assets?

Exhibit 6.6. Practical Measures of FX Exposure.