Chapter 13
Measuring Exposure to
Exchange Rates
We have established three important facts about the effect of exchange rate volatil-
ity on a firm’s value. First, changes in the nominal exchange rate are not offset
by corresponding changes in prices at home and abroad. That is, there are persis-
tent and significant deviations from purchasing power parity, implying that there
is real exchange rate risk (Chapter 3). Second, the forward rate is not success-
ful in forecasting the exchange rate nor are other fundamental variables (Chapter
10). Third, given the market imperfections in the real world, hedging exchange
rate risk can lead to an increase in the value of the firm (Chapter 12). We may
conclude, therefore, that at least some firms may want to hedge their exposure to
the exchange rate at least some of the time. The issue that is still unsettled is how
much should be hedged. Specifically, one issue is whether hedging of contractual
exposure, as discussed in Chapter 5, suffices: shouldn’t we hedge all “expected”
cashflows, whether contractual or not? And shouldn’t we also think of the effect of
exchange-rate changes on accounting values (as opposed to cash flows)?
In the first section of this chapter we distinguish between exchange-rateriskand
exposure to the exchange rate. We next explain how one can classify the effects
of exchange rate changes into two categories. First, exchange rate changes may
have an impact on accounting values (known asaccounting exposureortranslation
exposure). Second, the exchange rate may affect the firm’s cash flows and market
value (calledeconomic exposure), either through its effect on existing contracts
(labeledcontractual exposure ortransaction exposure) or through its impact on
the future operating cash flows of the firm (known asoperating exposure). Having
already discussed the hedging of contractual exposures in Chapter 5, our discussion
of this item here focuses on what it achieves, and where it stops, rather than on
the mechanics (Section 2). The rest of the chapter then considers operating and
translation exposure, in Sections 3 and 4, respectively.