An exchange rate fluctuation is not an isolated phenomenon. It is often associated with changes in aggregate demand and changes in price levels. Following a depreciation or appreciation in relevant exchange rates, a foreign subsidiary’s new economic value will emerge from the interaction of the new economic conditions, managements’ reactions to these conditions and the new exchange rate. Ideally, adjustments to operations will be able to compensate fully and quickly for any undesirable effects of exchange fluctuations. Unfortunately, the exigencies of competition often limit a firm’s ability to adjust its operations, so that it may experience for some period of time residual economic exposure to exchange risk. This residual exposure is the proper target for financial hedging policies.

The first step in hedging exchange risk is determining the extent of the firm’s exposure. Business commonly uses two definitions of exposure to exchange risk—(1) translation or accounting exposure, which measures the impact of exchange fluctuations on the firm’s book value and (2) transaction or conversion exposure, which measures the impact of fluctuations on cash flows identified with specific time periods. Neither definition considers the true economic value of the firm—the value of all its future operating cash flows.

Of the two traditional methods of measuring exposure to exchange risk, the author selects one—accounting exposure—to demonstrate that hedging policies that do not take account of the firm’s economic exposure can not only fail to reduce relevant exchange risk, but can actually increase the riskiness of the company by creating exposure where none existed before.