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}Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates.}An important task of the financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow, and market value of the firm.}The effect on a firm when foreign exchange rates change can be measured in several ways.
Conceptual Comparison of Transaction, Operating and Accounting Foreign Exchange ExposureMoment in time whenexchange rate changesAccounting exposure(Translation Exposure)Transaction exposureOperating exposure(Economic Exposure)TimeChanges in reported owners’ equityin consolidated financial statementscaused by a change in exchange ratesChange in expected future cash flows arising from an unexpected change inexchange ratesImpact of settling outstanding obligations entered into before changein exchange rates but to be settled after change in exchange rates
}Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change.}Thus, this type of exposure deals with changes in cash flows the result from existing contractual obligations.
}Operating exposure, also called economic exposure, competitive exposure, or strategic exposure, measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpectedchange in exchange rates.
}Transaction exposure and operating exposure exist because of unexpected changes in future cash flows. }The difference between the two is that transaction exposure is concerned with future cash flows already contracted for, while operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness.
}Accounting exposure, also called translation exposure, is the potential for accounting-derived changes in owner’s equity to occur because of the need to “translate” foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements.
}Hedging is the taking of a position, acquiring either a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position.}While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against.
}Firms can reduce exposure in many ways by choosing currency denomination on loans and by adjusting operations. For now we focus on financial contracts that can be used to reduce FX existing exposures.