FOREIGN EXCHANGE EXPOSURE

Foreign Exchange Exposure is one of the most common forms of risk faced by almost any firm, most individuals and even almost every country.  A fair definition of FX risk would be “the occurrence of outcomes different from expectations due to the volatility of Foreign Exchange currencies”.  Even if this exposure is so common, its management is not always adequate, and oftentimes we find firms struggling in recognizing the exposure and having an even harder time in hedging it.  This post discusses the main insights about FX exposure.

FX exposure comes in different forms, some of them are fairly easy to recognize, while some others are not easy to identify, and even harder to hedge.  The easiest form of FX exposure is the one that appears when a firm has cash flows denominated in different currencies.  This happens when a company operating in its local currency has a financial or commercial debt or credit denominated in a foreign one.  This exposure is usually easy to characterize and recognize.  If the firm has a credit in a foreign currency, its revaluation with respect to the local one will generate a profit and if the firm has a debt denominated in the foreign currency, its revaluation will generate a loss.  Recognizing this exposure is straightforward; finance departments of companies around the world know their foreign currency denominated cash flows and the exposure they generate.  Hedging this exposure, once it has been recognized, is also usually easy, and can be done through the use of FX derivatives or by setting up an operational hedge.  An easy example of an operational hedge would be the generation of an opposite position by taking a commercial debt of credit in the foreign currency in such a way that both exposures offset each other at a due time.  This type of exposure is usually referred as to Transaction Exposure since it usually appears because of a transaction or a concatenation of them.

A company, however, can have an exposure to FX risk even when all its cash flows are denominated in the same currency.  This happens when either: (i) its clients or customers; (ii) its suppliers, or; (iii) its competitors, operate in a different currency.  Consider the case of a firm that exports a given product, and in order to avoid the problems caused by having cash flows denominated in different currencies decide to sell their products in local currency (assuming that it has the market power to do so).  Even having all its cash flows denominated in the same –local- currency, it cannot avoid the fact that its clients and customers hold a different currency in their pockets.  If the foreign currency, the one in the clients’ pockets, depreciates with respect to the exporter’s local currency, its products will become essentially more expensive for the foreign clients to buy them, and the exporting firm is likely to lose sales and ability to compete in that market.  This effect is similar in the case in which a firm has to purchase supplies from a foreign firm.  Even if the importer is able to force the supplier to denominate the transactions in local currency, it still cannot escape the fact that the supplier might become less and less efficient and, in the extreme, it might even go bankrupt because of the FX volatility; this would change an FX risk into a Supply Chain Risk.  In a similar fashion, even when a firm only trades within its own country and in its own currency, it can still face significant FX exposure.  Consider the case that a foreign firm enters a firm’s local market with its products produced in another country and its costs denominated in a foreign currency.  If this foreign currency devaluates with respect to the local market currency, the foreign firm will have a cost advantage and the local firm’s ability to compete will be affected by the local currency overvaluation.

These type of situation is usually denominated Economic Exposure.  It is not attached to a particular transaction, rather it is a situation that stems from the competitive environment of the firm.  This type of exposure is hard to identify and mitigate.  In order to identify it firms need to have a very clear risk management understanding, and dealing with these exposures is usually more complex than just taking derivative positions; it usually entails decisions affecting operations, logistics, human resources, etc.  In the case of having identified this risk, and in the impossibility of restructuring the firm, and, at least partial solution, might be designed by taking positions in financial instruments that generate a gain when the FX volatility generates a loss.  This is, however, a more complicate and potentially incomplete way of hedging the exposure.

These exposures can affect not only a firm but also a whole country or region. This was the case of the loss of competitiveness of European firms when the euro revaluated with respect to the US dollar and the rest of the world currencies a few years ago.  As a result of that, most European firms started having a hard time competing in both the global and local markets, several of them moved their production facilities outside Europe, generating an economic slowdown and a large unemployment, whose consequences we are still witnessing nowadays.

There is another kind of FX exposure, the one that appears when assets denominated in a foreign currency need to be translated into a local currency, usually for reporting purposes.  These assets can be fixed assets or even liquid ones, like a production facility or a stream of dividends.  In both cases, the devaluation of the foreign currency would diminish the value of those assets for the local company, generating an FX exposure.  This type of exposure is usually referred as Translation Exposure, and is usually hard to identify and hedge.

Most of the times firms fail to identify all the different flavors of FX exposure, and simply recognize the traditional Transaction Exposure.  The problem is that the other exposures, especially the Economic Exposure, is likely to generate larger damage, especially if it is not seen in advance.  As usual, it is of paramount importance to identify and monitor the determinants of FX risks, so we can anticipate threats and opportunities in due advance.

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