9.1Forms of exposure to exchange rate risk

Exchange rate risk takes several forms. The simplest can be appreciated by con-

sidering the position of a British exporting company selling in the US market and

entering into a contract to supply goods over the next year. Payment is to be made

in US dollars within a stated period after the delivery of the goods. The British

company bases its sterling prices on its current production costs in the UK, but to

convert these into dollar prices must assume an exchange rate for sterling against

the dollar. The company is said to be longin dollars (it has net assets in dollars in

the form of the future payments to be received in dollars). The risk facing a com-

pany long in a foreign currency is that the foreign currency will weaken between

the signing of the contract and the settlement of the account. A company that owes

money in a foreign currency is said to be shortin that currency (it has net liabilities

in the foreign currency). The risk it faces is that the value of the foreign currency

will rise before it pays its debts. Market participants who are either long or short in

a foreign currency have an open position in the market.

Open position:At risk from a change in exchange rates – either long(assets in the

foreign currency greater than liabilities in it) or short (assets in the foreign currency less

than liabilities in it).

The form of exchange rate risk faced by the British exporting company above is

known as transaction exposure.

Transaction exposure:Exposure to foreign exchange risk deriving from cash ow

or current transactions that gure in a company’s income statements but not on its

balance sheet.

Translation exposure covers the case of a parent company with subsidiaries in

other countries, where there is a need to produce a nancial statement showing the

position of the whole group of companies. If the accounts of the subsidiaries involve

foreign currency-denominated assets and liabilities (on balance sheets or in income

statements), the translation of these into the group statement may involve foreign

exchange exposure.

Economic exposure,like transaction exposure, relates to cash ows but is concerned

with the impact on the present value of future cash ows of all changes associated

with the depreciation or appreciation of a currency. Consider more closely the British

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9.1 Forms of exposure to exchange rate risk

exporter selling its goods in the US. Remember that the risk the rm faces is that the

value of the US dollar will fall. Suppose, however, that there is ination in the US

and thus that the rm is able to sell its product for an increasing number of dollars.

Suppose further that the fall in the value of the dollar that occurs is just equal to the

difference in the rate of ination in the two countries (relative purchasing power

parity holds). In this case, the rm will be no worse off overall. There would be trans-

action exposure because a xed quantity of dollars would at a given time exchange

for fewer pounds. However, there would be no economic exposure because the

rm would have beneted from the difference in ination rates that had caused the

dollar to fall in value. Thus, one way of comparing the two types of exposure is to

say that transaction exposure arises from changes in nominal exchange rates while

economic exposure derives from changes in real exchange rates (when purchasing

power parity does not hold).

However, economic exposure is a rather broader concept than this implies. Consider,

for example, the impact on a UK exporting company of a fall in the value of sterling

in terms of dollars. The rm could take the benet of the fall in the value of sterling

by increasing its prot margins and leaving the dollar prices of its goods unchanged.

Its US dollar prots would convert into more sterling than before, but if UK ination

were higher than US ination and purchasing power parity held, the rm would

not have gained in real terms from the depreciation of sterling. On the other hand,

the rm could leave its prot margins unchanged and lower the prices of its goods

in dollars, increasing its sales and its market share in the US. In this case, we could

not say what the nal effect would be without information about the elasticity of

demand for the rm’s goods in the US.

Again, if the UK exporter used inputs imported from the US, it would face an

increase in the sterling price of those inputs. This would increase its costs and reduce

the gain made as a result of the sterling depreciation. The rm might also face prob-

lems in third markets, for instance if it were in competition in Japan with a German

rm. Of course, it might be able to protect itself in a different way by obtaining its

inputs from a different source than the US.

A British company competing with US imports in the domestic market would

gain from the fall in the value of sterling but the benet would be reduced by any

consequent increase in domestic ination. The extent of this ination would depend

on supply elasticities in the UK.

These examples of exposure to risk vastly understate the problems caused to indi-

vidual rms by exchange rate changes. Many rms both sell output and buy inputs

in a number of currencies, the relationships between which are constantly changing.

They must make investment decisions a long time in advance on assumptions made

about the likely prots from different operations. Expected prots in particular markets

can quickly be turned into losses by exchange rate changes. Firms may also suffer

from the foreign exchange problems of their customers or suppliers. It is no surprise

that the breakdown of the IMF xed exchange rate system in 1972 led to a great

demand from rms for means of protection against risk. A major form of protection

undertaken by rms was that of hedging foreign exchange risk.

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

Hedging foreign exchange risk:The act of reducing that risk by undertaking an

offsetting transaction in a derivative market. A British rm that is long in dollars and

thus risks losing should the value of the dollar fall hedges by taking out a contract in

a derivative market that would be protable should the value of the dollar fall.