Economic Exposure

What Is Economic Exposure?

Economic exposure is a type of foreign exchange exposure caused by the effect of unexpected currency fluctuations on a company’s future cash flows, foreign investments, and earnings. Economic exposure, also known as operating exposure, can have a substantial impact on a company’s market value since it has far-reaching effects and is long-term in nature. Companies can hedge against unexpected currency fluctuations by investing in foreign exchange (FX) trading.

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.

Unlike transaction exposure and translation exposure (the two other types of currency exposure), economic exposure is difficult to measure precisely and hence challenging to hedge. Economic exposure is also relatively difficult to hedge because it deals with unexpected changes in foreign exchange rates, unlike expected changes in currency rates, which form the basis for corporate budgetary forecasts.

For example, small European manufacturers that sell only in their local markets and do not export their products would be adversely affected by a stronger euro, since it would make imports from other jurisdictions such as Asia and North America cheaper and increase competition in European markets.

Economic exposure rises as currency volatility increases and is difficult to measure.

Special Considerations

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.

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.

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 U.S. company that gets about 50% of its revenue from overseas markets has factored in a gradual decline of the U.S. dollar against major global currencies — say 2% per annum — into its operating forecasts for the next few years. If the dollar appreciates instead of weakening gradually in the years ahead, this would represent economic exposure for the company. The dollar’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.