Last week, I presented at Thunderbird, the highest ranked international business school in the US.The topic was obviously foreign exchange and as I commenced the discussion I asked the audience for the two hour session not to be a monologue but a dialogue. I was very fortunate that these graduate students were top caliber, had genuine interest and great questions.One of the first questions were:Why do you talk about exposure and not risk, and what is exposure?
I thought that was an excellent question and worthy discussing further.
Exposure in its most generic term is defined as the condition of being unprotected, and investigating further is defined as the disclosure of something secret.When digging into FX one sees that it is clearly a piece or sections of sensitized material, applicable in both foreign exchange as well as photography.In the area of medicine acute as well as chronic exposures come to mind (short- and long-term respectively); both causing health effects that are immediate or can occur days or even years later.
All definitions whether in photography, medicine or foreign exchange lead to the root of solving a problem:managing exposure.In any case mismanagement will lead to bad pictures, significant impact on shareholder value and illnesses. While some may say I want to manage risk, the fundamental question remains what is the root of the risk.It is the exposure that causes the risk.
So for the purpose of FXbestpractices I begin with the fundamental definition of foreign exchange exposure being the state of laying open or bare, to danger; and the accessibility to anything that may affect, especially detrimentally a company’s well being.The laying bare to the danger are those currency exchange rate changes that influence the company’s value.
As a next step in foreign exchange best practices one will want focus on the more specific type of exposures, including accounting exposures, operating exposures, transaction exposures and translation exposures.
Accounting Exposure
The change in the value of a firm's foreign currency denominated accounts due to a change in exchange rates.
Operating exposure
Degree to which exchange rate changes, in combination with price changes, will alter a company's future operating cash flows.
Transaction exposure
Risk to a firm with known future cash flows in a foreign currency that arises from possible changes in the exchange rate.
Translation exposure
Risk of adverse effects on a firm's financial statements that may arise from changes in exchange rates.
FX Best Practices mandates that one understands one’s company’s exposures well.Today’s practices ( not best practices ) often are to accumulate numbers from all over and put them into a spreadsheet and with that calculate the exposure.At the surface that sounds correct.The issue however becomes how much does one really understand what one just calculated.Best practices today commands that one understands the outcome and where all numbers are derived from.The most common complaint from corporations is that the G/L not really reflects the currencies that are being remeasured well and that there is quite a lot of discussions about GIGO (garbage in garbage out).
I find this a scary discussion as most companies will tell you that they are not certain how good their data is to calculate the exposure, but this is just the way they have always done so and pray that they don’t get – what I refer to as the imminent surprise ( it will come ).If one does not understand the FX exposure, one subsequently will not understandthe risk, making it rather difficult to manage.Whenever I come across a company that does not hedge it is 90% of the cases because they don’t understand the exposure.
FX Best Practices: Look at exposure by finding analytical tools that help you not just represent what you already know from your systems ( not only but also G/L ) but for analytical tools that organize the data into an easily understood and intuitive format that can be verified by all. Ensure that the tool has processes and flexibility available the ensures a continuum and therefore increased confidence in ones data. Best practices today looks at shifting the middle office from data gatherers to data analysts and decision makers.
Once one has real confidence in ones data – the exposure – the risk calculation will fall into place and the decisions is what one can focus on.
