Reducing Economic Exposure

Reducing economic exposure requires strategic choices that go beyond the realm of financial management. The key to reducing economic is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates. The post 1985 trend by Japanese automakers to establish productive capacity in North America and Western Europe can partly be seen as a strategy for reducing economic exposure. Before 1985 most Japanese automobile companies concentrated their productive assets in Japan. However, the rise in the value of the yen on the foreign exchange market has transformed Japan from a low-cost to a high-cost manufacturing location. In response Japanese auto firms have moved many of their productive assets overseas to ensure their car prices will not be unduly affected by further rises in the value of the yen. In general, reducing economic exposure necessitates that the firm ensure its assets are not too concentrated in countries where likely rise in currency value will lead to damaging increases in the foreign prices of the goods and services they produce.

Reducing Transaction and Translation Exposure

A number of tactics can help minimize their transaction and translation exposure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates. We discussed two of these tactics buying forward and using change rates. They are import sources of insurance against the short-term effects of foreign exchange exposure.
In addition to buying forward and using swaps, firms can minimize their foreign exchange exposure through leading and lagging payables and receivable that is collecting and paying early or late depending on expected exchange rate movements. A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. A leg strategy involves delaying collection of foreign currency is expected to depreciate. Leading and legging involve accelerating payments from weak currency to strong-currency countries and delaying inflows from strong-currency from weak currency countries.
Lead and leg strategies can be difficult to implement, however. The firm must be in a position to exercise some control over payment terms. Firms do not always have this kind of bargaining power, particularly when they are dealing with important customers that are in a position to dictate payment terms. Also, because lead and lag strategies can put pressure on a weak currency, many governments limit lead and lags. For example some countries set 180 days as a limit for receiving payments for exports or making payments.
Several other tactics that can reduce transaction and translation exposure have already been discussed in this blog. We have explained that:

1. Transfer prices can be manipulated to move funds out of a country whose currency is expected to depreciate.

2. Local debt financing can provide a hedge against foreign exchange risk.

3. It may make sense to accelerate dividend payments from subsidiaries based in countries with weak currencies.

4. Capital budgeting techniques can be adjusted to deflect the negative impact of adverse exchange rate movements on the current net value of a foreign investment.