MANAGING

ECONOMIC AND
TRANSLATION
EXPOSURE
International Financial
Management
 Managing Economic and Translation
Exposure
 Cash flows of MNCs may still be sensitive to exchange rate movements
(economic exposure) even if anticipated international contractual
transactions are hedged. Furthermore, the consolidated financial
statements of MNCs may still be exposed to exchange rate movements
(translation exposure). By managing economic exposure and translation
exposure, financial managers may increase the value of their MNCs. In
general, it is more difficult to hedge economic or translation exposure
than to hedge transaction exposure.
Managing Economic Exposure
 Economic exposure represents any impact of exchange rate fluctuations
on a firm’s future cash flows. But what is the difference between
transaction exposure and economic exposure?
 Managing Economic and Translation
Exposure
 ‘Transaction vs Economic Exposure’ is equivalent to comparing short-term
vs. long-term impact on cash flow changes due to forex fluctuations in the
market. Transaction and economic exposure differ in various aspects.
Future receivables or payables in foreign currency drive transaction risk.
On the other hand, future currency cash inflows /outflows drive economic
exposure.
There are 6 points of difference to know:
 Cash Flow: Transaction exposure is driven by transactions that have
already been contracted for, and hence they are of a short-term nature.
Economic exposure is transaction exposure as well as operating exposure
which is related to future cash flows. These cash flows are not realized or
contracted for, and the exposure is more anticipatory in nature. Economic
exposure can arise due to changes in future sales, volume, pricing, or cost
profile.
 Managing Economic and Translation
Exposure
 Nature of Risk: In transaction exposure, the risk associated is limited to
the contract or transaction under discussion. In economic exposure, the
risk associated impacts the core value of a business rather than one
particular transaction or contract and is the risk to the present value of
future operating cash flows.
 Identification: Transaction risk is the most easily identifiable foreign
exchange risk, but given its anticipatory nature, economic exposure is not
easy to identify.
 Cause and Scope: Transaction exposure arises only when you enter into a
contract involving future receivables/payables in foreign currency. Hence
the scope remains narrow. Economic exposure can arise without having
any transaction exposure, and hence the scope remains wide. For
example, domestic cash flows can be impacted due to foreign competition
in the domestic market, linked to foreign exchange differences.
 Managing Economic and Translation
Exposure
 Characteristics: Transaction exposure is more technical and tactical in
nature, while economic exposure is linked to a firm’s strategy and hence is
fundamental in nature.
 Hedging Application: Transaction exposures are hedged more frequently by
most companies, but most firms seldom apply any hedging strategy for
managing economic exposure and believe in natural hedging.
Example:
 Facebook is commonly accessed by many customers outside of the United
States. When it first established a credit system for users to make purchases
online, it required that all payments be in U.S. dollars. Consequently, these
transactions were not subject to transaction exposure. However, they were
subject to economic exposure because it is more costly for European
customers to make purchases online when the euro is weak, which could
cause these customers to make fewer purchases and thus reduce Facebook’s
cash inflows.
 Managing Economic and Translation
Exposure
 In 2012, Facebook revised its credit system so that its users could make
purchases in their local currency. This is more desirable for many non-U.S.
users, but it means that Facebook is directly exposed to exchange rate
movements. If the euro weakens, Facebook is adversely affected because
the euros it receives are converted into fewer dollars. Whether Facebook
requires payment in dollars or allows payment in the foreign currency,
these transactions are subject to economic exposure, because a change in
the value of the foreign currencies could affect the dollar cash inflows that
Facebook receives.
 Any U.S.-based MNC could require that all transactions be in dollars to
avoid transaction exposure. But that does not eliminate its economic
exposure. Thus, MNCs cannot focus just on hedging their foreign currency
payables or receivables but must also attempt to determine how all their
cash flows will be affected by possible exchange rate movements.
 Managing Economic and Translation
Exposure
Measurement of Economic Exposure
 An MNC must determine how it is subject to economic exposure before it
can manage its economic exposure. It must measure its exposure to each
currency in terms of its cash inflows and cash outflows. Information for
each subsidiary can be used to derive estimates.
 Economic exposure is the sensitivity of the future home currency value of
the firm’s operating cash flow to random changes in exchange rates.
 There exist statistical measurements of sensitivity.
 Sensitivity of the future home currency values of the firm’s assets and liabilities to
random changes in exchange rates.
 Sensitivity of the firm’s operating cash flows to random changes in exchange rates.
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