ABSTRACT
We identify operating exposure as the most important and difficult to manage component of exchange risk. Our model identifies three components of foreign exchange exposure: direct operating exposure, the market demand effect, and the competitive effect. The size and relative importance of these components depends critically upon international market structure and firm strategies. We derive implications for managing foreign exchange exposure. Internationalisation of the economies of most nations has meant that companies are increasingly subject to the risk associated with exchange rate movements. Despite consensus over the importance of exchange rate risk, the ability of companies to effectively manage these risks has been limited by confusion over the definition of such risk and the appropriate tools for managing exchange rate risk. In terms of both defining and controlling exchange rate risk, a fundamental distinction is between accounting exposure and economic exposure (Lessard and Lightstone 1986, Oxelheim and Wihlborg 1987). Accounting exposure arises from the need to report the firm’s financial condition and results in a common currency. The financial statements of foreign operations are converted from the local currencies involved to the reporting currency.1 Accounting exposure is the variance in the book value of the firm resulting from changes in the home currency value of foreign currency-denominated assets and liabilities. Although accounting exposure has received considerable attention in the international finance literature, its relevance to managerial decision making is doubtful. Since management’s goal is supposedly to operate in the interests of its owners by maximising the market value of the firm, the basic problem with accounting exposure is that book values bear little relation to shareholders’ wealth maximisation.
