Economic Exposure Explained, With Mitigation Strategies

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.

Key Takeaways

  • Economic exposure is a type of foreign exchange exposure caused by the effect of unexpected currency fluctuations.
  • Exposure increases as foreign exchange volatility increases and decreases as it falls.
    Economic exposure is a risk for multinational companies that have numerous subsidiaries overseas and many transactions involving foreign currencies.
  • Though economic exposure is a large concern for multinational companies, due to the advent of globalization, many businesses can experience economic exposure.
  • Economic exposure can be mitigated either through operational strategies, such as the diversification of production facilities, or currency risk mitigation strategies, such as currency swaps.

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 U.S. company that earns approximately 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.

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.

Article Sources
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  1. Yale School of Management. "Why Does Market Volatility Matter?"

  2. C. T. Bauer College of Business, University of Houston. "Chapter VIII: Currency Risk Management at the Firm Level," Page VIII.1.

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