Yet another dimension of exchange risk involves the element of time. In the very
short run, virtually all local currency prices for real goods and services (although not
necessarily for financial assets) remain unchanged after an unexpected exchange rate
change. However, over a longer period of time, prices and costs move inversely to
spot rate changes; the tendency is for Purchasing Power Parity and the Law of One
Price to hold.
In reality, this price adjustment process takes place over a great variety of time pat-
terns. These patterns depend not only on the products involved, but also on market
structure, the nature of competition, general business conditions, government poli-
cies such as price controls, and a number of other factors. Considerable work has
been done on the phenomenon of “pass-through” of price changes caused by (unex-
pected) exchange rate changes. And yet, because all the factors that determine the ex-
tent and speed of pass-through are very firm-specific and can be analyzed only on a
case-by-case basis at the level of the operating entity of the firm (or strategic busi-
ness unit), generalizations remain difficult to make. Exhibit 6.5 summarizes the firm-
specific effects of exchange rate changes on operating cash flows.
6.4 IDENTIFYING EXPOSURE 6 • 17WHAT IS ECONOMIC EXPOSURE?
Let us offer an example. PDVSA, the Venezuelan state-owned oil company, recently set up an
oil refinery near Oslo, Norway, for shipment to Germany and other continental European
countries. The firm planned to invoice its clients in euros, the currency unit of the European
Union. The treasurer is considering sources of long term financing. In the past all long-term
finance has been provided by the parent company, but working capital required to pay local
salaries and expenses has been financed in Norwegian kroner. The treasurer is not sure
whether the short-term debt should be hedged, or in what currency to issue long term debt.
This is an example of a situation where the definition of exposure has a direct impact on
the firm's hedging decisions.
Translation exposure has to do with the location of the assets, which in this case would be
a totally misleading measure of the effect of exchange rate changes on the value of the unit.
After all, the oil comes from Venezuela and is shipped to Germany: its temporary resting
place, be it a refinery in Oslo or a tanker en route to Germany, has no import. Both provide
value added, but neither determine the currency of revenues. So financing should definitely
not be done in Norwegian kroner.
Transactions exposure has to do with the currency of denomination of assets like accounts
receivable or payable. Once sales to Germany have been made and invoicing in euros has
taken place, PDVSA Norway has contractual, euro-denominated assets that should be fi-
nanced or hedged with euros. For future sales, however, PDVSA Norway does not have ex-
posure to the euro. This is because the currency of determination in the oil business is the U.S.
dollar.
Economic exposure is tied to the currency of determination of revenues and costs. Since
the world market price of oil is dollars, this is the effective currency in which PDVSA's future
sales to Germany are made. If the euro rises against the dollar, PDVSA must adjust its euro
price down to match those of competitors like Aramco. If the dollar rises against the euro,
PDVSA can and should raise prices to keep the dollar price the same, since competitors
would do likewise. Clearly the currency of determination is influenced by the currency in
which competitors denominate prices.
The conclusion is, therefore, that the Norwegian subsidiary of a Venezuelan company
whose sales to Germany are invoiced in euros should do its long term financing in U.S. dol-
lars, to hedge the effective currency of exposure.
Exhibit 6.5. Exposure Concepts: Currency of Location versus Currency of Denomination
versus Currency of Determination.