The relation between firm value, or future cash flows, and exchange rate risk is complex. "Firm value" is the expected cash to be made from the firm both now and in the future. There is no specific requirement that firm value refer to "guaranteed" future cash flows. Therefore, this relationship is not one that is amenable to exact, mathematical certainty.
"Firm value" is about investor confidence in the ability of a firm to produce dividends or capital gains. This concept is a technical one, since it deals with the overall health of a firm rather than mere capitalization at one point in time. Given the fact that "firm value" is such a complex set of both objective and subjective variables, many times foreign currency exposure is already factored into the evaluation of the firm.
Exchange Rate Exposure
Exchange rate exposure is another technical term that refers to the measurable amount of sales, assets or supplies that are valued in non-domestic currency. Exchange rate exposure is far more mathematically precise than firm value, but the two together are often elusive. First, most investors are already hedged against currency changes. Second, the market capitalization of a firm has the exposure variable already part of the valuation process.
Exchange rate exposure has significant effects on firm value only under certain circumstances. Putting it simply, it matters only when a substantial proportion of the firm's value is in other currencies. But this can be hedged with sheer size. In other words, the larger the firm, the more ability it has to hedge its assets in anticipation of exchange rate changes because it can command more power in foreign markets. Therefore, a large firm with 30 percent of its capital in other currencies is not hedged against a 30 percent exchange rate change. It might be valued for 10 percent, since the larger the firm, the less effect exchange rate variation has on its value. Alternatively, smaller firms with larger foreign assets and markets might be valued lower over time since they are more vulnerable.
Exchange rate exposure often calls for methods of protecting firm value against losses caused by currency changes. Two important means for doing this are "options" and "forwards." A "forward" is when a firm is expecting to do a great deal of business in another currency in the near future. To protect against any adverse exchange rate changes, the firm will buy -- at today's value -- the necessary currency to carry out its transactions. An "option" is the same thing, except there is no contractual necessity to actually act on the purchase if there are changes in the future. In both cases, firm size is yet again the most important variable. Large firms with great command over foreign markets have the power to make options their regular mode of doing foreign business. In this case, exchange rate changes will have no real short term effect on the firm. The real issue, therefore, is for small firms with few hedging mechanisms.
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