Currency Exposure

Currency exposure is the degree to which the value of a business, a portfolio or a payment flow is affected by movements in exchange rates. A company that sells goods priced in US dollars but pays its staff in euros has currency exposure, because a fall in the dollar reduces its euro income. So does an investor holding foreign shares, a bank with foreign currency loans, or a payment provider that collects funds in one currency and pays out in another. The exposure is the amount at risk; the possible loss or gain from rate changes is foreign exchange risk.

Exposure is measured in each currency and over time. It can be reduced through hedging with derivatives, by matching assets and liabilities in the same currency, or by changing how prices and contracts are set. Managing currency exposure is a core task of corporate treasury and of risk management in banks and payment firms.

• Transaction exposure. The risk that the home-currency value of a specific foreign currency payment or receipt changes between the time it is agreed and the time it is settled. An importer that must pay a supplier 1 million yen in 90 days has transaction exposure until it pays.
• Translation exposure. Also called accounting exposure, the risk that the reported value of foreign subsidiaries' assets, liabilities and profits changes when converted into the parent's reporting currency for financial statements.
• Economic exposure. Also called operating exposure, the longer-term effect of exchange rate changes on a firm's future cash flows and competitive position, even if it has no foreign currency contracts. A domestic manufacturer competing with imports is exposed if the foreign competitor's currency weakens.
• Balance sheet exposure. In banks and payment firms, the net open position in each currency, meaning the difference between foreign currency assets and liabilities.

The simplest measure is the net position in each currency: expected inflows minus expected outflows over a period, or foreign currency assets minus foreign currency liabilities. Treasury teams build forecasts by currency and time bucket and then estimate how much the home-currency value would change for a given move in rates. For example, a net receivable of 2 million US dollars for a euro-based company changes in euro value by about 2% of its value if the dollar moves 2% against the euro. More advanced methods, such as value at risk and scenario analysis, estimate potential losses across many currencies at once, taking account of how rates move together.

Firms use a mix of operational and financial techniques:

• Natural hedging. Matching revenues and costs in the same currency, for example by sourcing locally or borrowing in the currency of foreign income. See natural hedge.
• Netting. Offsetting payables and receivables across subsidiaries so that only the net amount is exposed and converted, as described under FX netting.
• Forward contracts. Fixing the rate for a future conversion with an FX forward contract.
• Options. Buying an FX option to protect against adverse moves while keeping some benefit from favourable ones.
• Swaps. Using currency swaps to convert foreign currency debt or long-term flows.
• Pricing and invoicing. Invoicing in the home currency, adding exchange rate adjustment clauses or pricing in a stable currency to shift exposure to the counterparty.

A hedging policy sets out which exposures are hedged, how much, for how long and with which instruments. Accounting rules on hedge accounting allow companies to match the timing of gains and losses on hedges with the underlying exposures, reducing volatility in reported profit.

Payment providers, remittance companies and card issuers are exposed whenever they promise a customer a rate before they have converted the funds, or when they pre-fund payouts in foreign currencies. A remittance firm that quotes a fixed rate to a sender and converts later bears the risk that the rate moves in the meantime. Such firms manage exposure by converting quickly, limiting how long quotes remain valid, setting limits on open positions and holding balances with liquidity providers in key currencies. Regulators may require firms to hold capital against open currency positions.

Hedging reduces uncertainty but does not remove all exposure. Forecasts of future cash flows may be wrong, leaving firms over- or under-hedged. Economic exposure is hard to hedge with financial instruments because it depends on competitors, customers and prices over many years. Hedging also has costs, including forward points, option premiums and collateral requirements, and it can produce visible losses if rates move in the firm's favour. For these reasons many firms hedge only a share of their exposure and review the policy regularly.