Firm Currency Exposure - Moving Beyond Transactional

Not a week goes by when we read a story in the media on how a high and rising Canadian dollar affects exporters. (See: Get ready for a $1.15 loonie) The story is typically one of transactional exposure - a company has a revenue stream in U.S. dollars and the value of that stream is reduced when the Canadian dollar appreciates.

However, that is not the only type of exchange rate exposure a firm needs to concern itself with.  There are two others.

The first is translational currency exposure (also known as accounting exposure), which covers assets and liabilities denominated in a foreign currency, as well as translating the financial statements of foreign subsidiaries into domestic currencies.  While this may not apply to most small-businesses, there are ways to use a translational exposure to offset a transactional one.  For instance, a Canadian exporter with a net transactional exposure to the U.S. dollar could borrow in that currency, providing an offsetting transactional exposure (interest payments) and offsetting translational exposure (the Canadian dollar value of the debt).  You need to be somewhat careful when considering transactional and translational exposures, because the former tends to be flows while the latter tends to be stocks, so it's not an apples-to-apples comparison.

The second is competitive currency exposure, which considers how the competitive landscape of an industry changes due to the change in exchange rate.  I'll explain using an example:

You're a North American automaker that has no net transactional or translational currency exposure with the Japanese yen - you purchase very little from Japan and you sell almost no cars there.  However, you compete for sales in North America with Toyota and Honda, who purchase a great deal of parts from Japan as well as assemble some (but not all) of their cars there.

What is the effect on your company if the Japanese yen depreciates by 20-30%?  If we only examined transactional and translational currency exposure, the answer would be "nothing".  However, there will be a significant competitive exposure: Toyota and Honda's manufacturing costs, when measured in U.S. dollars, have fallen significantly.  They can use this to their advantage to gain market share, either by cutting prices (while still retaining healthy margins) or use some of the added profits to increase advertising and expansion efforts.

The moral of the story is that even Canadian firms that source within Canada and do not export can still be affected by the U.S.-Canadian exchange rate.  If you're competing with a company that has a different exchange rate exposure than yours, you have a competitive exchange rate exposure.

Comments

[Rick]

A few Questions:
Is the savings realized in a currency depreciation solely related to salaries, wages, and benefits?

If a large company is using roll over financing to cover such expenses on a month to month basis and the depreciation is accompanied by a lower interest rate for domestic loans (In that foreign country) won't that increase their advantage, not only in the present, but also in the future showing up as returns on the present "free" capital spent on Marketing, R&D, and other such things?

[JP Koning]

I like these c-dollar pieces, very practical.

Ages ago you wrote: "The three traps that, in my view, are easy to fall into are as follows:
Conflating the issue of a high Canadian dollar with a rising Canadian dollar. (I plan on writing a separate piece on this in the future)."

Did I miss the follow-up or are you going to take a swing at that in the future?

Is it just me or is the tone of the chatter shifting in favor of currency intervention, see http://www.theglobeandmail.com/report-on-business/economy/economy-lab/daily-mix/loonie-in-death-grip-carnie-should-act-cibc/article1841995/

Given the Potash deal being nixed, I don't think this administration is averse to such dealings.

[short tar, long on species]

A basic trade strategy would be to import from the USA as their dollar depreciates and export to nations like Chindia/Brazil before their dollar appreaciates, ignoring the USA exposure. Buy GE and sell Embraer.