MANAGING ECONOMIC EXPOSURE

Economic Effects of Unanticipated Exchange Rate Changes on Cash Flows .
From this analytical framework, some practical implications emerge for the assessment of economic exposure. First of all, the firm must project its cost and revenue streams over a planning horizon that represents the period of time during which the firm is "locked-in," or constrained from reacting to (unexpected) exchange rate changes. It must then assess the impact of a deviation of the actual exchange rate from the rate used in the projection of costs and revenues.
STEPS IN MANAGING ECONOMIC EXPOSURE
1. Estimation of planning horizon as determined by reaction period.
2. Determination of expected future spot rate.
3. Estimation of expected revenue and cost streams, given the expected spot rate.
4. Estimation of effect on revenue and expense streams for unexpected exchange rate changes.
5. Choice of appropriate currency for debt denomination.
6. Estimation of necessary amount of foreign currency debt.
7. Determination of average interest period of debt.
8. Selection between direct or indirect debt denomination.
9. Decision on trade-off between arbitrage gains vs. exchange risk stemming from exposure in markets where rates are distorted by controls.
10. Decision about "residual" risk: consider adjusting business strategy.
Subsequently, the effects on the various cash flows of the firm must be netted over product lines and markets to account for diversification effects where gains and losses could cancel out, wholly or in part. The remaining net loss or gain is the subject of economic exposure management. For a multiunit, multiproduct, multinational corporation the net exposure may not be very large at all because of the many offsetting effects.7 By contrast, enterprises that have invested in the development of one or two major foreign markets are typically subject to considerable fluctuations of their net cash flows, regardless of whether they invoice in their own or in the foreign currency.
For practical purposes, three questions capture the extent of a company's foreign exchange exposure.
1. How quickly can the firm adjust prices to offset the impact of an unexpected exchange
rate change on profit margins?
2. How quickly can the firm change sources for inputs and markets for outputs? Or,
alternatively, how diversified are a company's factor and product markets?
3. To what extent do volume changes, associated with unexpected exchange rate
changes, have an impact on the value of assets?
Normally, the executives within business firms who can supply the best estimates on these issues tend to be those directly involved with purchasing, marketing, and production. Finance managers who focus exclusively on credit and foreign exchange markets may easily miss the essence of corporate foreign exchange risk.