Measurement of a firm’s economic exposure to foreign exchange risk—that is, the sensitivity of the firm’s economic value, or share price, to exchange rate changes—is simplified if one considers separately the basic components of economic exposure. These are financial exposure and natural exposure.
A firm’s financial exposure will depend on the extent to which financial hedges such as debt service on foreign currency debt and forward foreign exchange contracts reduce foreign exchange exposure; this may be determined from the data in the financial statements. The natural component of foreign exchange exposure recognizes that changes in foreign returns and unexpected declines in the value of a foreign currency are frequently associated with unexpected increases in inflation forecasts, so that dollar returns are naturally hedged to the extent that these unexpected increases in inflation increase foreign currency returns. The firm’s total natural exposure will depend on the extent to which a devaluation is commensurate with foreign relative inflation and on the extent to which net foreign currency cash flows can be immediately and fully adjusted to inflation.
A firm’s total exposure to foreign exchange rate changes is derived by subtracting the proportion of the firm’s value that is naturally hedged from the proportion of the firm’s value that is not financially hedged. When applied to a hypothetical firm operating in several foreign countries, this approach suggests that firms’ economic values are considerably less sensitive to foreign exchange risk than accounting conventions imply.