International Finance: Putting Theory Into Practice

13.1. THE CONCEPTS OF RISK AND EXPOSURE: A BRIEF SURVEY 493

Figure 13.1:Exposure Concepts: an Overview

P. Sercu and R. Uppal The International Finance Workbook page 2.18

3. Exposure concepts: overview (1)
   3. Exposure—overview

future S

outstanding

contracts in

FC

economic

conditions,

home& abroad

HC cashflow

one-to-one,

perfect hedge

indirect, imperfect

hedge

accounting

rules chosen

book values

?

taxes

?

??

CONTRACTUAL OPERATING TRANSLATION

Key Contractual in- or outflows can be hedged peso-for-peso, if there really is no other risk.
Operating exposures imply a noisy, convex relation between exchange rates and (hc-measured)
cash flows, so the hedge is imperfect. Even getting a good idea of that relation is far from obvious:
it requires a good understanding of the business and its environment. Translation exposure, lastly,
primarily affects book values rather than cash flows—except indirectly if and when changed book
values generate tax effects.
.

fcthat matures on that date. It includes, per currency and per date, allA/R,

A/P, deposits and loans denominated in a givenfc, forward currency contracts,

and contracts to buy or sell goods in future at knownfcprices (Chapter 5).

(Note that not all required information is found in the accounting system:

commodity contracts where no delivery has been made yet, have not yet given

rise toA/PorA/R, but they do generate contractual flows.) The exposureB

then is thefcvalue, which is assumed to be risk-free.

• Operating exposure In the case of operating exposure one looks at the
  firm not as a portfolio offccontracts signed in the past and generating cash
  in- or outflows in the future, but as a set of activities that require constant
  decisions by management, customers, and competitors. These future decisions
  depend, among other things, on future exchange rates, so that the cashflows
  are exposed in bothfcandhcterms. (In the case of contractual exposure,
  in contrast, thefcamount is by assumption fixed, and only thehcvalue
  depends on the exchange rate.) In short, hereV ̃Tis the cash flow from future
  operations rather than from past contracts, and thefccash flow,C∗, is not a
  constant but depends on the future spot rate,S ̃T, and possibly other variables
  X ̃T:V ̃T=C∗(S ̃T,X ̃T)×S ̃T.


• Translation exposure(or, less aptly,accounting exposure) arises when a
  multinational company has to consolidate its financial statements. As all sub-
  sidiaries’ balance sheets and income statements are originally drawn up in the
  local currency, they must be translated first, and the result of this inevitably
  depends on the exchange rate at the reporting date.