FINA01052383 - Tutorial 3 Problem Set

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THE UNIVERSITY OF HONG KONG

FACULTY OF BUSINESS AND ECONOMICS

FINA0105/2383A – International Financial Management

FIRST SEMESTER, 2014-2015

Tutorial 3 – Chapter 9 Management of Economic Exposure

(Continue with Tutorial Problem Set 2 Question 2, 4 & 5)

Question 1 (Asset Exposure)

Suppose that you hold a piece of land in the City of London that you may want to sell in one

year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if

the British economy booms in the future, the land will be worth £2,000 and one British pound

will be worth $1.40. If the British economy slows down, on the other hand, the land will be

worth less, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British

economy will experience a boom with a 60% probability and a slow-down with a 40%

probability.

(a) Estimate your exposure b to the exchange risk.

(b) Compute the variance of the dollar value of your property that is attributable to the

exchange rate uncertainty.

(c) Discuss how you can hedge your exchange risk exposure and also examine the

consequences of hedging.

Question 2 (Asset Exposure)

Suppose you are a British venture capitalist holding a major stake in an e-commerce start-up

in Silicon Valley. As a British resident, you are concerned with the pound value of your U.S.

equity position. Assume that if the American economy booms in the future, your equity stake

will be worth $1,000,000, and the exchange rate will be $1.40/£. If the American economy

experiences a recession, on the other hand, your American equity stake will be worth

$500,000, and the exchange rate will be $1.60/£. You assess that the American economy will

experience a boom with a 70% probability and a recession with a 30% probability.

(a) Estimate your exposure to the exchange risk.

(b) Compute the variance of the pound value of your American equity position that is

attributable to the exchange rate uncertainty.

FINA0105/2383 – International Financial Management Tutorial Problem Set 3

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(c) How would you hedge this exposure? If you hedge, what is the variance of the pound

value of the hedged position?


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Chapter 9 – Management of Economic Exposure

� What is Economic Exposure?

� Changes in exchange rates can affect not only firms that are directly engaged

in international trade but also purely domestic firms.

� If the domestic firm’s products compete with imported goods, then their

competitive position is affected by the strength or weakness of the local

currency.

Example: Consider a U.S. bicycle manufacturer who sources, produces, and

sells only in the U.S.

� Since the firm’s product competes against imported bicycles, it is subject to

foreign exchange exposure.

� Their customers are comparing the cost and features of the domestic bicycle

against Japanese, British, and Italian bicycles.

� Exchange Rate Risk and Economic Exposure

� Exchange rate risk is applied to the firm’s competitive position.

� Any anticipated changes in the exchange rates would already have been

discounted and reflected in the firm’s value.

� Economic exposure can be defined as the extent to which the value of the

firm would be affected by unanticipated changes in exchange rates.


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� How to Economic Exposure?

� Economic exposure is the sensitivity of the future home currency value of

the firm’ s assets and liabilities and the firm’s operating cash flow to random

changes in exchange rates.

There exist statistical measurements of sensitivity:

- Sensitivity of the future home currency values of the firm’s assets and

liabilities to random changes in exchange rates.

- Sensitivity of the firm’s operating cash flows to random changes in

exchange rates.

Example: If a U.S. MNC were to run a regression on the dollar value (P) of its

British assets on the dollar-pound exchange rate, S($/£), the regression would be

of the form:

P = a + b × S + e

where

a is the regression constant

e is the random error term with mean zero

the regression coefficient b measures the sensitivity of the dollar value of the

assets (P) to the exchange rate, S.

The exposure coefficient, b, is defined as follows:

where Cov(P,S) is the covariance between the dollar value of the asset and the

exchange rate, and Var(S) is the variance of the exchange rate.


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Two Sources of Economic Exposure

The exposure coefficient shows that there are two sources of economic

exposure:

(1) The Variance of the exchange rate

(2) The Covariance between the dollar value of the asset and exchange rate

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FINA01052383 - Tutorial 3 Problem Set