: Managing Economic Exposure and Translation Exposure

6 Part 3: Exchange Rate Risk Management 346 12: Managing Economic Exposure and Translation Exposure As the previous chapter described, MNCs can manage the exposure of their international transactions to exchange rate movements (referred to as transaction exposure) in various ways. Nevertheless, cash fl ows of MNCs may still be sensitive to exchange rate movements (economic exposure) even if anticipated international transactions are hedged. Furthermore, the consolidated fi nancial statements of MNCs may still be exposed to exchange rate movements (translation exposure). By managing economic exposure and translation exposure, fi nancial managers may increase the value of their MNCs. The specific objectives of this chapter are to: ■ explain how an MNC’s economic exposure can be hedged, and ■ explain how an MNC’s translation exposure can be hedged. In general, it is more diffi cult to effectively hedge economic or translation exposure than to hedge transaction exposure, for reasons explained in this chapter. Economic Exposure From a U.S. fi rm’s perspective, transaction exposure represents only the exchange rate risk when converting net foreign cash infl ows to U.S. dollars or when purchasing foreign currencies to send payments. Economic exposure represents any impact of exchange rate fl uctuations on a fi rm’s future cash fl ows. Corporate cash fl ows can be affected by exchange rate movements in ways not directly associated with foreign transactions. Thus, fi rms cannot focus just on hedging their foreign currency payables or receivables but must also attempt to determine how all their cash fl ows will be affected by possible exchange rate movements. Nike’s economic exposure comes in various forms. First, it is subject to transaction exposure because of its numerous purchase and sale transactions in foreign currencies, and this transaction exposure is a subset of economic exposure. Second, any remitted earnings from foreign subsidiaries to the U.S. parent also reflect transaction exposure and therefore reflect economic exposure. Third, a change in exchange rates that affects the demand for shoes at other athletic shoe companies (such as Adidas) can indirectly affect the demand for Nike’s athletic shoes. Nike attempts to hedge some of its transaction exposure, but it cannot eliminate transaction exposure because it cannot predict all future transactions. Moreover, even if it could eliminate its transaction exposure, it cannot perfectly hedge its remaining economic exposure; it is difficult to determine exactly how a specific exchange rate movement will