Exposure to Currency Risk: Definition and Measurement

This article examines the exposure of electric utilities to foreign currency risk in the U.S. Corporations that are based in the U.S., including those with no foreign operations and no foreign currency assets, liabilities, or transactions, are generally exposed to foreign currency risk. Regional electrical utilities are a somewhat extreme case in point. With no foreign currency accounts on their books, they have no accounting exposure to exchange risk. From an economic perspective, however, the story is different. If their customer base is dominated by either importing or exporting firms whose activities and demand for electricity are affected by exchange rate changes, the electrical utilities operations and stock prices themselves will also in principle be exposed to exchange risk. Accounting rules for foreign currency translation are largely powerless in this situation. Economic exposure to foreign currency risk must be defined and measured quite apart from the choice between current or historical exchange rates for translating particular foreign currency positions. What is needed, in short, is to replace the accounting approach with a technique for measuring the economic exposures of the market prices of financial and physical assets. This is done in the pages that follow which draw out the implications for practice of recent innovations on the theoretical front. The objective, it should be noted, is limited to definition and measurement; it is not the analysis of the determinants of exchange risk or exposure thereto. It is also not to analyze whether individuals or firms should hedge. These last are important problems which are best addressed once the exposure phenomenon itself has been precisely identified. Section 1 distinguishes between currency risk and exposure. The latter is defined in Section II and measured in Section 111. The practical implications of the approach are discussed in Sections IV and V.