Economic exposure is a type of foreign exchange risk that results from long-run unanticipated changes in exchange rates affecting future cash flows through their effect on competitive position, sales growth, pricing and cost structure.
Economic exposure affects a company’s cash inflows and cash outflows broadly such that the company’s ultimate valuation is affected. It affects the profitability of a company’s business model and its strategic position.
Economic exposure differs from transaction exposure in that the transaction exposure results in gain or loss on individual transactions which are already executed but not yet settled but the economic exposure stems from unexpected changes in revenues and costs in the long run that result from foreign exchange movements. Economic exposure also differs from translation exposure (also called accounting exposure) because translation exposure affects the accounting income when foreign currency financial statements of subsidiaries are translated to the reporting currency while the economic exposure affects the cash inflows and outflows of the parent and/or subsidiaries itself.
Let’s consider a US company which generates its major revenue in Euros. If in the long run the Euro depreciates against the US Dollar, the US Dollar value of its Euro-denominated revenue stream will fall thereby reducing its free cash flow and hence adversely affecting its shareholders wealth. The opposite applies to a company whose major costs are denominated in foreign currency. Let’s consider Apple, Inc. who must pay Chinese companies in renminbi. If renminbi depreciates with respect to US Dollar, Apple will be required to pay less US Dollars to Chinese companies. It will fatten the company’s free cash flows and its stock price will increase.
Management of economic exposure
Out of all three main foreign exchange exposures, i.e. transaction exposure, translation exposure and economic exposure, economic exposure is the most difficult to manage. It is because the foreign exchange rates are determined by a myriad of factors such as inflation rates, interest rates, fiscal policy, monetary policy, etc. which are outside a company’s control. Unlike economic exposure can’t be managed through derivative contracts such as forwards, futures, options and swaps. However, the impact of economic exposure can be reduced through the following strategies:
- Diversifying its revenue stream in terms of the currencies involved. There is a possibility that impact of appreciation in one currency can potentially offset the impact of depreciation in another currency.
- Locating its operations in different countries depending on its target markets. For example, setting up plants in different currency zones will naturally hedge the cash inflows and outflows because exposure to revenues will be offset by exposure to costs if both are in the same currency.
- Borrowing in foreign currency if significant revenue is from that currency. In this case, a slowdown in revenues due to foreign currency movement will be partially offset by reduction in interest related cash outflows.