Economic Risk

Also known as operating exposure, this refers to the effect on a company's market value from exposure to unpredictable currency fluctuations. This can impact a company's future cash flows, external grants and earnings.

Economic exposure can have a substantial impact on a company's market value. Exposure is better for multination companies with many oversea branches and a large number of transactions involving foreign currencies. Globalization has increased economic exposure for all companies. Effects are far-reaching and long-term in nature. Economic exposure is difficult to measure precisely.

Because of this, hedging against economic exposure can be challenging as it deals with unexpected changes in foreign exchange rates. However, there are way to mitigate this risk.

Understanding Economic Exposure

The degree of economic exposure is directly proportional to currency volatility. Economic exposure increases as foreign exchange volatility increases and decreases as it falls.

Economic exposure is obviously greater for multinational companies that have numerous subsidiaries overseas and a huge number of transactions involving foreign currencies; however, increasing globalization has made economic exposure a source of greater risk for all companies and consumers.

Economic exposure can arise for any company regardless of its size and even if it only operates in domestic markets.

Mitigating Economic Exposure

Economic exposure can be mitigated either through operational strategies or currency risk mitigation strategies. Operational strategies involve diversification of production facilities, end-product markets, and financing sources, since currency effects may offset each other to some extent if a number of different currencies are involved.

Currency risk-mitigation strategies involve matching currency flows, risk-sharing agreements, and currency swaps. Matching currency flow means matching cash outflows and inflows with the same currency, such as doing as much business as possible in one currency, including borrowings. Currency swaps allow two companies to effectively borrow each other's currencies for a period of time.

Example of Economic Exposure

Assume that a large UK company that earns approximately 50% of its revenue from overseas markets has factored in a gradual decline of the Pound Sterling (GBP) against major global currencies; say 2% per annum into its operating forecasts for the next few years.

If the Pound Sterling (GBP) appreciates instead of weakening gradually in the years ahead, this would represent economic exposure for the company. The Pound's strength means that the 50% of revenues and cash flows the company receives from overseas will be lower when converted back into dollars, which will have a negative effect on its profitability and valuation.

The company would have to employ currency risk-mitigation strategies to hedge against any adverse moves from an incorrect calculation. It might employ a small FX trading desk within the firm to help reduce exposure to adverse currency fluctuations.

How Do You Manage Economic Exposure?

Economic exposure is managed through two overarching strategies: operational strategies and currency risk-mitigation strategies. Operational strategies include diversification in production facilities and the markets the products are sold, flexibility in sourcing raw materials, and diversifying financing sources. Currency risk-mitigation strategies include matching currency flows, currency swaps, risk-sharing agreements, and back-to-back loans.

What Is Currency Exposure?

Currency exposure is the change in an asset's return due to fluctuations in a foreign currency when the asset's return is measured in the domestic currency. In general, currency exposure is the increase or decrease in an asset's value in the domestic currency due to changes in the value of a foreign currency. This is often measured in relation to a company's profits that are earned overseas and have to be converted back into its domestic currency.

What Is the Main Purpose of Economic Exposure Management?

The main purpose of economic exposure management is to reduce the impact that changes in exchange rates have on the cash flows of a company. Economic exposure management seeks to help companies preserve as much foreign profit as they can when profits in foreign currencies are converted to the domestic currency.