Economic Exposure

AAA

DEFINITION of 'Economic Exposure'

A type of foreign exchange exposure caused by the effect of unexpected currency fluctuations on a company’s future cash flows. Also known as operating exposure, economic exposure can have a substantial impact on a company’s market value, since it has far-reaching effects and is long-term in nature.

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.

INVESTOPEDIA EXPLAINS 'Economic Exposure'

For example, assume that a large U.S. company that gets about 50% of its revenues 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 U.S. dollar appreciates instead of declining 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.

Increasing globalization has made economic exposure a source of greater risk for companies. The degree of economic exposure is directly proportional to currency volatility. Economic exposure increases as foreign exchange volatility rises, 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, economic exposure can arise for any company regardless of its size and even if it only operates in domestic markets.

For example, small European manufacturers that only sell 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 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.

RELATED TERMS
  1. Exchange Rate

    The price of a nation’s currency in terms of another currency. ...
  2. Overnight Limit

    The number of currency positions a trader can carry over from ...
  3. Export

    A function of international trade whereby goods produced in one ...
  4. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  5. Import

    A good or service brought into one country from another. Along ...
  6. Forex - FX

    The market in which currencies are traded. The forex market is ...
Related Articles
  1. A Primer On The Forex Market
    Options & Futures

    A Primer On The Forex Market

  2. Getting Started In Foreign Exchange ...
    Forex Education

    Getting Started In Foreign Exchange ...

  3. Getting Started In Forex
    Options & Futures

    Getting Started In Forex

  4. 6 Factors That Influence Exchange Rates
    Bonds & Fixed Income

    6 Factors That Influence Exchange Rates

comments powered by Disqus
Hot Definitions
  1. Accounts Payable - AP

    An accounting entry that represents an entity's obligation to pay off a short-term debt to its creditors. The accounts payable ...
  2. Ratio Analysis

    Quantitative analysis of information contained in a company’s financial statements. Ratio analysis is based on line items ...
  3. Days Payable Outstanding - DPO

    A company's average payable period. Calculated as: ending accounts payable / (cost of sales/number of days).
  4. Net Sales

    The amount of sales generated by a company after the deduction of returns, allowances for damaged or missing goods and any ...
  5. Over The Counter

    A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase "over-the-counter" ...
  6. Earnings Before Interest After Taxes - EBIAT

    A financial measure that is an indicator of a company's operating performance. EBIAT, which is equivalent to after-tax EBIT ...
Trading Center