What is economic exposure and transaction exposure? How is economic exposure different from transaction exposure?

Extent to which a firm’s market value in dollars) is sensitive to unexpected changes in foreign currency is referred as economic exposure. Economic exposure relates to ‘cash flow risks. The term cash flow has been defined in different ways. Cash flow means

(i) the total net dividends and liquidation proceeds available to the owners over future years,

(ii) the free cash flow,that is earnings before depreciation minus capital expenditure minus increases in working capital, 

(iii) the future earnings of the company defined in such a way as to reflect cash earnings rather than earnings computed on the accrual concept of accounting. The following distinguishing features apply to cash flow risk:

One, the threat is to the competitiveness of costs; it affects the ability of the business to compete, to obtain sales at a remunerative margin of profit over cost.

Two, the threat is from movements of the real, not the nominal exchange rate. A rise in the real rate of exchange erodes either margins or sales volume or a mixture of both.

Rise and fall in the real exchange rate of selling currencies tend to affect all competitors, and are part of the wider phenomenon of macro-economic uncertainty which every business must manage. It is thus not primarily a currency risk. This is a trading risk. All businesses have to watch the forces which affect demand and supply of what they are offering. This is a wider macroeconomic risk and not just a currency risk. Currencies are an important part, but not the whole of the relevant economic environment.

Consequently, if there are only two competing suppliers one with French and one with German costs, and if the bulk of sales are in the USA or in US dollars, a fall in the real exchange rate of the dollar would not cause economic or competitiveness risk.

Three, the risk are concerned with future sales for which prices have not yet been quoted. In these cases, management is concerned with nominal, ‘not real exchange rates. Competitiveness risk, thus, excludes all potential sales for which the busiin has quoted prices, as well as actual sales, regardless of whether they have reached the balance sheet as receivables or payables. 

Four, the threat is to the competitive position of a business. Strictly, it is to a business in one or more of its commercial markets, where it incurs appreciable costs in a currency which may become less competitive. Economic exposure depends on the unique characteristics of an industry and the individual characteristics of an individual firm. Potential currency risk (unpredictable, ____ _____ _________ ______ ____.
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