Economic Exposure: Definition and Effects
The global economy and the financial markets are an interconnected ecosystem. The Forex market, which operates 24/5, and fluctuates constantly, is an integral part of this ecosystem and therefore companies, consumers, and governments can experience the impact of currency movements to varying degrees. This is known as economic exposure. Though it is also referred to as operating exposure or business exposure.
A sub-type of Forex exposure, economic exposure directly impacts cash flows, revenues, costs, and overall profitability. It can influence inflation, job creation, and economic expansion. Managers can deploy numerous methods to measure economic exposure and deploy strategies to mitigate its effects.
Another way to look at economic exposure is to view it as the sensitivity of a company’s financial performance to Forex fluctuations.
An Example of Economic Exposure
Assume US-based Company ABC expands its business to the UK and the Eurozone.
- It sources raw materials from Chile, paid for in Chilean Pesos
- It sources raw materials from Japan, paid for in Brazilian Reals
- It records US-based revenues in US Dollars
- It records UK-based revenues in British Pounds
- It records EU-based revenues in Euros
- It must convert everything to US Dollars on its income statement and balance sheet
Since the Forex market fluctuates 24/5, Company ABC must actively manage its economic exposure to ensure its ongoing success. It may plan for a 3.5% depreciation in exchange rates but assume the US Dollar appreciates 5.0%. It will impact raw material costs and non-US Dollar revenues, weakening its financial health, which can have broad-based effects.
Even small, domestic companies can experience economic exposure via inflation, monetary policy changes, completion, outsourcing, scarcity of materials and employees, and input costs.
What Does Economic Exposure Impact?
Economic exposure can impact companies to varying degrees, depending on their overall operational management.
The most notable areas economic exposure can impact are:
- Revenues
- Costs
- Financing
- Competition
How to Measure Economic Exposure
Companies have various methods to measure economic exposure, which will determine how they mitigate it.
Here are the most common methods to measure economic exposure:
- Cash Flow at Risk (CFaR), which measures the potential impact of Forex fluctuations on future cash flows
- Net Present Value (NPV) analysis, which discounts future cash flow to present cash flow values
- Sensitivity analysis, which provides an overview of how Forex fluctuation can impact metrics like revenues, costs, profitability, and market share
- Value at Risk (VaR), which measures potential losses related to adverse Forex fluctuation
- Regression analysis, which identifies the statistical relationship between financial performance and Forex fluctuations
- Scenario analysis, which provides a simulation of how Forex fluctuation can impact financial performance
How to Mitigate Economic Exposure
While companies cannot avoid economic exposure, they can actively manage it to lower the adverse impact.
Here are some economic exposure mitigation strategies:
- Currency hedging - one of the most used economic exposure mitigation strategies, via Forex and options trading, forward-contracts usage, or currency swaps
- Diversification of the operational base across countries of core markets
- Local currency financing by subsidiaries
- Pricing strategies that consider historical Forex rates
- Operational efficiencies to reduce input costs of foreign-sourced components
Conclusion
Economic exposure impacts daily life, but companies can actively manage and mitigate its adverse influence. Companies experience the most economic exposure, followed by consumers and governments.
FAQs
What is economic exposure in real life?
Economic exposure is the impact of currency fluctuations, which influences the entire ecosystem.
For example, if companies in the US experience economic exposure causing higher operating expenses and lower profits, they may raise prices, which fuels inflation. Alternatively, they can absorb higher input costs, but it diminishes available capital for business expansion, potentially lowering job creation and having a negative economic impact.
Is economic exposure long-term?
Economic exposure is long-term, as the Forex market operates 24/5, and the global economy is an interconnected ecosystem, meaning that a change in one area, especially if it sits at the core of the supply chain, will ripple through the global economy and impact businesses, consumers, and governments.
What is the difference between accounting and economic exposure?
Economic exposure measures the long-term impact of currency fluctuation on the business and requires active management to minimize negative events.
Accounting exposure focuses on the immediate impact of economic exposure on the balance sheet covering the reporting period.
What is economic exposure also known as?
Economic exposure is a sub-type of Forex exposure, also known as operating exposure or business exposure.
What are the types of economic exposure?
The types of economic exposure include revenue exposure, cost exposure, competitive exposure, and financing exposure.
How do you overcome economic exposure?
Companies can overcome and manage economic exposure through currency hedging, diversification, local currency financing, pricing strategies, and operational efficiencies.