Economic exposure is a variation in the economic value or market value of a company due to changes in exchange rates. Currency fluctuations impact a company’s financial stability.
When a company invests or operates in more than one country, changes in exchange rates can expose their cash flows, revenues and profits. Economic exposure can have a major impact on a company’s market value because it has long-term effects.
To mitigate this, companies can hedge. Or, they diversify market sources to generate revenue in different currencies.
How economic exposure works
To understand this concept, I will take a simple example.
A company gets about 60% of its revenue from the United States market. Management assumes a gradual depreciation of the rupiah against the US dollar, say 1.5% per year, into its operating forecast for the next two years.
Depreciation means the company’s products will be cheaper in the United States market. Therefore, the company targets high sales growth, say 15% per year for two years. To support increased sales, the company has increased production and has purchased new machines. The company has taken a 5-year loan from a domestic bank to finance the investment.
Say, the exchange rate assumptions are off. The rupiah exchange rate against the US dollar apparently strengthened during those two years. Sales fell 15% as appreciation made products more expensive in the United States market.
Appreciation causes cash flow problems for companies. Since 60% of revenue comes from the United States, the company collects lower dollars from sales. Appreciation makes the conversion of US dollar sales into rupiah less.
At the same time, the company must pay regular loans from the bank. Ultimately, appreciation has a negative impact on a company’s profitability and cash flow. As cash flow worsens, it makes the company’s value valuation fall.