Hedging Economic Exposure
Economic risk or exposure reflects the degree to which the present value of future cash flows may be affected by exchange rate moves. However, exchange rate moves are themselves related through PPP to differences in inflation rates. A corporation whose foreign subsidiary experiences cost inflation exactly in line with the general inflation rate should see its original value restored by exchange rate moves in line with PPP. In that case, some may argue economic exposure does not matter. However, most corporations experience cost inflation that differs from the general inflation rate, which in turn affects their competitiveness relative to competitors. In this case, economic exposure clearly does matter and the best way to hedge it is to finance operations in the currency to which the corporation’s value is sensitive.
July 4th, 2009