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Measuring and Managing Economic Exposure

Chapter 11

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PART I.FOREIGN EXCHANGE RISK AND ECONOMIC

EXPOSURE

I. FOREIGN EXCHANGE RISK

Economic exposure focuses on the impact of currency fluctuations on firm’s value.

Changes in PV of the firm (long term) as a result of changes in the exchange rate

Expectations about the fluctuation must be incorporated in all decisions of the firm.

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

Definitions:a. Accounting exposure (past) impact on firm’s balance sheet

b. Economic exposure•Transaction (contractual,

present/future, short term)•Operating (future, long term)

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

Real Exchange Rates and RiskNominal vs real exchange rates

• Real rate has been adjusted for price changes, and reflect the relative purchasing powers.

• Real rate changes may result in Hobson’s Choice: (“We don’t like either choice!”) When faced with a change in real value,– do you keep price constant

(changing sales)– do you change prices (change profits)

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

The economic impact of a currency change depends on the offset by the difference in inflation rates or the real exchange rate.

It is the relative price changes that ultimately determine a firm’s long-run exposure.

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PART II.THE ECONOMIC CONSEQUENCES OF

EXCHANGE RATE CHANGES

A. Transaction exposure•On-balance sheet (existing

contracts)•Off-balance sheet (contracts in the

future, leases, loan repayments)

Assumption (flawed)LC costs and revenues remain

constant

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THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES

B. Operating Exposure : real rate change leading to changes in relative prices and demand for your and for competitors’ products.

Based on pricing flexibility which depends on elasticity of demand.

– Product differentiation

Substitution of inputs and shifting production

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THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES

II. SUMMARY– The sector of the economy in

which the firm operates; – The sources of the firm’s

inputs; – Fluctuations in the real

exchange rate

delineate the firm’s true economic exposure.

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PART III.IDENTIFYING ECONOMIC

EXPOSUREI. CASE STUDIES OF ECONOMIC EXPOSURE

A. APEN SKIING COMPANY1. Firm’s exchange rate risk affected

its sales revenues.2. Although there was no translation

risk, the global market with its exchange rate risk and

competitors impacted market demand.

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IDENTIFYING ECONOMIC EXPOSURE

B. PETROLEOS MEXICANOS (PEMEX)1. The firm’s exchange rate risk

affected cost but not revenues.2. Economic impact

a. Revenues: none ($ pricing)

b. Costs: decreasedc. Net effect:increased US$

flows

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IDENTIFYING ECONOMIC EXPOSURE

C. TOYOTA MOTOR COMPANY1. Exchange rate risk affected BOTH

revenues and costs.2. Trying to decrease exposure may

result in Flow back effect:previously exported goods returnwith increased domestic

competition and lower profit margins domestically

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PART IV.CALCULATING ECONOMIC

EXPOSURE

A quantitative assessment of economic exposure depends on underlying assumptions concerning:– future cash flows;– sensitivity to exchange rate

changes.

Case for Spectrum Manufacturing AB

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PART V.AN OPERATING MEASURE OF

EXCHANGE RISKA workable approach can be

Regression Analysis– Variables:

•changes in parent’s cash flows•Average nominal exchange rate change

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AN OPERATING MEASURE OF EXCHANGE RISK

– Output measures:•Estimated Beta coefficient :

measures the association of changes in cash flows to exchange rate changes.

• the higher the percentage change of cash flow

to changes in exchange rates, the greater the economic exposure (higher beta values).

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PART VI.MANAGING OPERATING

EXPOSUREOperating exposure management requires long-term operating adjustments.

Adjustments/decisions are related to marketing, production and finance.

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MANAGING OPERATING EXPOSURE

II. Marketing Management Adjustments

A. Market Selectionuse pricing advantage to carve out

market share (domestic or foreign)

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MANAGING OPERATING EXPOSURE

B. Pricing strategy:1. If HC value falls, exporter gains

competitive advantage by increasing unit profitability and/or market share.

2.The higher price elasticity of demand, the more currency risk the firm faces by product subsitution.

3. Following HC depreciation, local firm may have much more freedom in its pricing.

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MANAGING OPERATING EXPOSURE

C. Product Strategyexchange rate changes may

alter1. The timing of new product

introductions/deletions

2. Product innovation (for decreasing elasticity)

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MANAGING OPERATING EXPOSURE

III. Product Management Adjustments

A. Input mixB. Shift production among

plantsC. Plant locationD. Raising productivity

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MANAGING OPERATING EXPOSURE

IV. Planning For Exchange-Rate Changes

With better planning and more competitive options, firms can change strategies substantially before the impact of an currency change makes itself felt.

Implication: compaction of adjustment period following an exchange-rate

change.

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MANAGING OPERATING EXPOSURE

V. Financial Management of Exchange Rate Risk: Financial manager’s Role in Marketing and Production

– Provide local manager with forecasts of inflation and exchange rate changes

– Identify and focus on competitive exposure

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MANAGING OPERATING EXPOSURE

– Design the evaluation criteria so that operating managers neither rewarded or penalized for unexpected exchange-rate changes.

– Estimate and hedge the operating exposure after adjustments made.

– Currency matching (asset-liability, casf flow)