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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A US automaker sells cars domestically and competes with a Japanese rival. It has no foreign-currency contracts, but a sustained yen depreciation lets the rival cut USD prices, reducing the automaker's future sales and margins. This risk is best classified as:

It is economic exposure. The automaker has no yen contracts or foreign subsidiaries, but yen depreciation changes competitors' relative prices and so reduces its future operating cash flows. Such competitive effects are hard to hedge with simple forwards and typically require operational or strategic responses.

  1. AEconomic exposure, because uncontracted future cash flows depend on exchange ratesCorrect
  2. BTransaction exposure, because a contract is denominated in yen
  3. CTranslation exposure, because balance sheet items must be restated
  4. DSettlement exposure, because a payment may fail to be delivered

Explanation

No contract is denominated in yen, so it is not transaction exposure. No foreign subsidiary is consolidated, so it is not translation. The effect works through competitive position on future operating cash flows, which defines economic (operating) exposure.

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