rate fluctuations. This problem has been accentuated over the past 15 years as we have observed several episodes of exchange rate overshooting relative to purchasing power parity. For example, during the 1980s and early 1990s, the U.S. dollar moved for several years in one direction against the currencies of the other major industrial nations, before beginning its correction relative to purchasing power parity.
Traditionally, a company's exchange rate exposure has been viewed as consisting of cash flow and translation dimensions. The cash flow dimension in turn has two components: flows that are "contractual," called transactions exposures; and flows that are noncontractual in nature and usually longer term in time perspective. The latter cash flow effects we identify as "operating" exposures (also known as "economic" or "competitive" exposures). Operating exposure effects occur as unexpected changes in exchange rates alter the firm's input costs and the revenue derived from product sales. The effects of exchange rate changes will depend upon the firm's underlying supply and demand elasticities in the input and product markets, as well as competitor reactions in these markets.
The translation dimension arises in an accounting context and focuses on the balance sheet value of the parent company's equity. Balance sheet magnitudes can be affected by changes in the value of foreign currency assets and liabilities, when restated in the parent's home currency. As this exposure concept arises from accounting procedures, the exposure per se does not have cash flow implications. Under FAS 52 (the current rate method), this change is not recorded in the income statement of the MNC, but rather flows directly to a special equity account in the consolidated statement of the parent corporation. 2 It is unusual for companies operating under FAS 52 and similar current rate accounting approaches to hedge translation exposures. Surveys indicate that few MNCs hedge this exposure dimension; for example, see Johnson ( 1995). Accordingly, the focus in this chapter is on foreign exchange rate effects arising from transaction and operating exposures.
Regarding transaction exposures, the traditional view is that financial instruments (e. g., forward exchange contracts) can be used to offset transaction exposures. This works only when the maturity of the hedging contract matches the company's decision horizon, as in the case of a single short-term transaction. Most MNCs, however, have foreign currency cash flows that are regular, frequent, certain and that arise from the normal pattern of business. Because these flows are ongoing for the foreseeable future, the MNC has essentially a long-term exposure which cannot be addressed using the traditional financial hedging approaches. For example, in the case of an MNC facing a long term declining foreign exchange rate, the company must reset its six-month hedges at the lower exchange rate at the end of each consecutive six-month contract period. Where MNCs face long cycle exchange rate trends, transaction exposures will come to have a character similar to operating exposures.
One reason for the limited success of several previous studies may be their use of aggregation across companies. By nature, foreign exposure is highly company specific, with considerable differences among the companies. When a