510 CHAPTER 13. MEASURING EXPOSURE TO EXCHANGE RATES
transactions exposure) and operating exposure. Managers typically focus on con-
tractual exposure, which arises from accounts receivable, accounts payable, long-
term sales or purchase contracts, or financial positions expressed in foreign currency.
This is because if one’s source of information is accounting data, as it typically is,
then transaction exposure is very visible and easy to measure. In contrast, oper-
ating exposure is much harder to quantify than contractual exposure; it requires a
good understanding of competitive forces and of the macroeconomic environment
in which the firm operates. For many firms, however, operating exposure is more
important than contractual exposure, and it is critical that you make an attempt
to identify and measure the exposure of operations to exchange rates.
Also, it is incorrect to assume that a firm with no foreign operations is not
exposed to the exchange rate. For example, if a firm’s competitors are located
abroad, then changes in exchange rates will affect that firm’s competitive position
and its cash flows. Another common fallacy is the presumption that a policy of
systematic hedging of all transaction exposure suffices to protect the firm against
all exchange rate effects. As explained above, even if a firm perfectly hedges all
contractual exposure, its operations are still exposed to the exchange rate.
Whether one considers transaction or operating exposure, one can use a forward
contract (or the equivalent money-market hedge) to hedge the corresponding uncer-
tainty in the firm’s cash flow. Recall, however, that a forward or spot hedge is a
double-edged sword. It is true that bad news about future operations is offset by
gains on the forward hedge. However, you would likewise lose on the forward hedge
if the exchange rate change improves the value of your operations. For example, in
1991, the Belgian group Acec Union Mini`ere had hedged against a “further drop”
of theusd. Instead, theusdrose, causing losses of no less thanbef900m on the
forward contracts. Four managers were fired. If you dislike this symmetry implicit
in the payoff of a forward contract, you may consider hedging with options rather
than forwards, to limit the downward risk without eliminating potential gains from
exchange rate changes. As one banker once put it, “with a forward hedge you could
end in the first row of the class or in the last; with an option, at worst you end
somewhat below the middle.”
A second potential problem that a treasurer needs to be aware of, when using
short-term forward contracts to hedge long-term exposure, is the possibility of ruin
risk, that is, liquidity problems that arise when there is a mismatch between the
maturity of the underlying position and the hedging instrument. These liquidity
concerns already came up in our discussion about hedging with futures contracts
that are marked to market, but they arise any time the hedge triggers cash flows
that come ahead of the exposed cash flow itself, for instance if a five-year exposure
is covered by five consecutive one-year contracts.
Third, remember that, unlike many contractual exposures, operating exposure
cannot be obtained from a balance sheet or a pro formaP&Lstatement. It has to
be deduced from a cross-sectional analysis of possible future outcomes—cash flows,
typically. The level of the true exposure can be totally out of the ballpark of the sizes