Managing Exposure - Basic Concept

Fahmi Gustiawan

MANAGING EXPOSURE – AN ANALOGY FOR COUNTRY RISK AND BUSINESS I. BASIC CONCEPT A. GENERAL PICTURE Generally to business concept, exposure refers to the degree to which a company is affected by exchange rate (Alan C, Shapiro, 1999). We know nowadays, exchange rate play in important role in the economic, not only to business, also to the each country in the world. Basically, there are three (3) types of exposure (Mudrajad Kuncoro, 1996), such as: 1. Transaction Exposure 2. Translation/accounting exposure 3. Economic Exposure Each exposure has unique purpose and condition related to them. We will describe one by one shortly in this blog and also how well they work in the reality. Bellow is general picture (frame work) of when the exposure is happen. Picture 1-1, Exposure type and event Time of Exchange Rate Change Occurs

Accounting Exposure

Economic Exposure

Transaction Exposure

1. Accounting Exposure This exposure arises from the need for purposes of reporting and consolidation, to convert the financial statement of an organization that has FX transaction. 2. Transaction Exposure Shapiro said that this exposure results from transaction that give arise to known, contractually-binding future foreign currency denominated cash inflows or outflows. Means that, the FX (Foreign Exchange Rates) change in between the transaction settle and now (spot right as today), will leading to currency gains and losses. This focuses on to what happened with the all transaction recorded and still outstanding compare with today situation. It is also addressed to measure changes of financial liability before FX changed. 3. Economic (Operating) Exposure This exposure measures the extent to which currency fluctuation can alter a company’s future value (measured by current value from cash flow expected). The measurement is depending on the effect of FX change over the revenue, price and cost in the future. Means from now (today), how an organization will has a value with today and future FX rate. Economic exposure has two major issues and the cause root, namely Transaction Exposure and Operating Exposure. Whilst transaction exposure has been defined above,

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the Operating exposure arises because currency fluctuation (the volatile of currency) can alter a company’s future revenues and costs-that is, its operating cash flows (Shapiro, 1999). Consequently, measuring a firm’s operating exposure requires a longer-term perspective, viewing he firm as on going concern (exactly is sustainability instead of going concern) with operations whose cost and price competitiveness could be affected by exchange rate changes. B. ANALOGY TO BUSINESS A corporation usually has transaction. The transaction event for domestic company will have foreign exchange rate transaction directly and/or indirectly. No matters of the type of company size, type and soon, they will affected from the foreign exchange rate. For an example, local (domestic) company that produce/sell vegetables. Most of vegetables material resulted from local/domestic. Industry buy from the farmer, sell directly to consumer and/or re produce to become other finished material and sell it to consumer. Let say there’s no production chain (buy from farmer and sell directly to consumer), the impact is still there. We might be understood that before the farmer harvest, they need to buy the seeds. Off course the seeds have cost. These costs is related with the industry where they in. If they imported play significant role, then there’s effect to foreign exchange rate. It will imply to the seed price they sell. Event they (the manufacturer side) not have foreign exchange transaction, when their country face the foreign transaction effect, it will trigger the value of seeds. Let say, when the value of US$ appreciated to IDR (we can say that IDR has depreciated against to US$), then the country economic has FX problem. This FX problem will effect to country condition, such as, high inflation, high interest rate, etc. This all problem will relate to the seed price (and all prices as general). However, the degrees of effect from FX depend on the how many FX content in the transaction they have. As many as they have, then the FX will become major influence to the value of the company, respectively to this statement. Let’s we briefly describe one by one of the exposure above. B.1. Accounting Exposure Generally, accounting measure value of company based on what they recorded on their book. As per we saw in the picture 1-1 above, this accounting side can not truly account for the economic (we talking about cash flow). No matter retrospective accounting technique has been refined, it only tell now and last time. It is because these effects are primarily prospective in nature (Shapiro, 1999). However, it doesn’t mean that accounting statements are irrelevant. They are really useful to start looking of what happened of one organization from last a start period (depend on the purpose) to the end of period (“now”-in the picture above). Without the data or information state “clearly” in their recording, we can not understand easily. However, in this statement, we should also consider how an organization will have value for the future (sustainability concept). The stockholder of the corporation will tend to maximize their wealth instead of close the company and/or open the other company.

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For example:

Picture 1-2 above is under current rate method. However, others method (such as monetary/non monetary, temporal or current/non current method) is only different to volatile of translation gain or loss. However, as statement above (No matter retrospective accounting technique has been refined, it only tell now and last time). Next question and important is, how the effect changes of FX for the future company cash flow? It is hard o say as FX change is volatile and caused by several reason (such as, politics, demand of one of several denominated currency, etc). B.2. Transaction Exposure Transaction exposure and accounting exposure usually seems overlap. However, they are not synonymous. Company’s transaction exposure measured currency by currency and equals he difference between contractually fixed future cash inflows and outflows in each currency. Some of transactions are already listed on the firm’s balance sheet, whilst other obligation such as contract for future sales or purchases, are not (Shapiro, 1999). To pure understand, we can see as per description above (re transaction exposure) in this simple flow of transaction exposure as bellow: Picture 1-3, Simple transaction exposure flow T1 T2

Seller quotes a FX to buyer

Buyer sent a PO to seller at FX on T1

Quotation Exposure

Potential Exposure Exist

T3

T4

Seller dispatch the goods/services and invoicing them

Backlog Exposure

Buyer settles the payment as per quote on T1

Billing Exposure

Potential become real transaction exposure because transaction happened

Source: David K.Eiteman and Mudrajad K with several editing

As stated above, sales and/or purchases are not listed to accounting exposure. They are not listed in the balance sheet until become payable or receivable as reported in their

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books (we called at the billing exposure stage). Please see the time difference (from T1 to T4), there will a FX movement (whether the FX has appreciate or depreciate). The time they quote and the time they really place order and until payment will have exposure. The degree of exposure is depending on the volatile of transaction currency. So, in this case we are clear what is different between accounting exposure and transaction exposure. For many corporations it has been clear that example stated in their circumstances. B.3. Economic Exposure Two (2) first exposures are measuring short and medium time frame. Do not like those exposures, economic exposure tends to measuring of long term sustainability of company. However, this exposure subject to assumption, because it is depend on changes of future cash flow in arbiter time (Mudrajat K, 1996). In the other word, economic exposure is not came from accounting process, but it came from operation side. This exposure is total responsible to management as it is wholly interaction to finance, marketing, purchasing, production and all related function in the organization. Measuring the economic exposure usually has difficult effort because it is impossible to assess the effect of an exchange rate change without simultaneously considering the impact on cash flow of the underlying relative rates of inflation associated with each currency. As explained in the definition above, economic exposure has 2 major issues (operating and transaction exposure). An organization will be faced operating exposure when it invests in servicing market subject to foreign competition or in sourcing goods or input abroad. This investment includes new-product development, a distribution network, foreign supply contract, or production facilities. Transaction exposure will arise later on, and only if the company’s commitments lead it to engage in foreign currencydenominated sales or purchase (see picture’s 3). In other word, transaction exposure resulted from operating exposure, in simple way: “no operation” then “no transaction” (a linearity concept). Nowadays, Economic exposure has plays significant rule in the business and government. Many corporations (especially the one that has foreign currency transaction) and the country (used to major play in developing/development country, but now almost all country facing the situation) and for this reason, they must be carefully to plan and make a strategy related to their business or policy. We can make an example for economic exposure as bellow (picture 1-4).

Source from: Alan C, Shapiro (measuring Economic Exposure) with some edited by writer