minder is necessary because most commonly accepted notions of foreign exchange
risk hedging deal with assets; that is, they are pertinent to (relatively simple) finan-
cial institutions where the bulk of the assets consists of (paper) assets that have con-
tractually fixed returns (i.e., fixed income claims, not equities). Clearly, such time-
honored hedging rules as “finance your assets in the currency in which they are
denominated” applies in general to banks and similar firms. However, nonfinancial
business firms have, as a rule, only a relatively small proportion of their total assets
in the form of receivables and other financial claims. Their core assets consist of in-
ventories, equipment, special-purpose buildings, and other tangible assets, often
closely related to technological capabilities that give them earnings power and thus
value. Unfortunately, real assets (as compared to paper assets) are not labeled with
currency signs that make foreign exchange exposure analysis easy. Most importantly,
the location of an asset in a country is, as we shall see, an all too fallible indicator of
their foreign exchange exposure.
The task of gauging the impact of exchange rate changes on an enterprise begins
with measuring its exposure, the amount, or value, at risk. This issue has been
clouded because financial results for an enterprise tend to be compiled by methods
based on the principles of accrual accounting. Unfortunately, this approach yields
data that frequently differ from those relevant for business decision making, namely
future cash flows and their associated risk profiles. As a result, considerable efforts
are expended, both by decision makers as well as students of exchange risk, to rec-
oncile the differences between the point-in-time effects of exchange rate changes on
the enterprise in terms of accounting data, referred to as accounting or translation ex-
posure, and the ongoing cash flow effects, which are referred to as economic expo-
sure. (See also Coppe, Graham, and Koller, 1996.) Both concepts have their ground-
ing in the fundamental concept of transactions exposure. The relationship between
the three concepts is illustrated in Exhibit 6.2. While exposure concepts have been
aptly analyzed elsewhere in this Handbook, some basic concepts are repeated here to
make the present chapter self-contained.
Measures of translation exposure have a grounding in simple transactions expo-
sure. But economic exposure deals with exchange rate effects on future transactions.
6.4 IDENTIFYING EXPOSURE 6 • 9Exhibit 6.2. Three Concepts of Exposure. Measures of translation exposure have a ground-
ing in simple transactions exposure, but economic exposure deals with exchange rate effects
on future transactions.