Economic Exposure

Economic exposure is the extent to which a firm's future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs. This is distinct from transaction exposure, which is concerned with the effect of exchange rate changes on individual transactions, most of which are short-term affairs that will be executed within a few weeks or months. Consider the effect of the wide swings in the value of the dollar on many US firms' international competitiveness during the 1980s. The rapid rise in the value of the dollar on the foreign exchange market in the early 1980s hurt the price competitiveness of many US producers in world markets. US manufacturers that relied heavily on exports (such as Caterpillar) saw their export volume and world market share plunge. The reverse phenomenon has occurred since the mid1980s, when the dollar has declined against most major currencies. The fall in the value of the dollar between 1985 and 1995 increased the price competitiveness of US manufacturers in world markets and helped produce an export boom in the United States.

Tactics and Strategies for Reducing Foreign exchange Risk,

A number of strategies and tactics can help firms reduce their foreign exchange exposure. The tactics, which include buying forward and the use of leading and lagging, are best suited to alleviating transaction exposure and translation exposure. The strategies addressing the configuration of a firm's assets across countries are best suited to reducing economic exposure.

Reducing Transaction and Translation Exposure

A number of tactics can help firms minimize their transaction and translation exposure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates. We discussed two of these tactics in Chapter 9, buying forward and using currency swaps. They are important sources of insurance against the short-term effects of foreign exchange exposure. (For details, return to Chapter 9.)

In addition to buying forward and using swaps, firms can minimize their foreign exchange exposure through leading and lagging payables and receivables--that is, collecting and paying early or late depending on expected exchange rate movements. A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Leading and lagging involves accelerating payments from weak-currency to strong-currency countries and delaying inflows from strong-currency to weak-currency countries.

Lead and lag strategies can be difficult to implement, however. The firm must be in a position to exercise some control over payment terms. Firms do not always have this kind of bargaining power, particularly when they are dealing with important customers who are in a position to dictate payment terms. Also, because lead and lag strategies can put pressure on a weak currency, many governments limit leads and lags. For example, some countries set 180 days as a limit for receiving payments for exports or making payments for imports.

Several other tactics that can reduce transaction and translation exposure have already been discussed in this chapter. We have explained that: