Foreign Exchange Exposure

1
Foreign Exchange Exposure
2
Foreign Exchange Exposure
How do we measure the exchange rate risk facing
an MNC? Foreign exchange exposure is defined as
the degree to which a company is affected by
exchange rate changes. The magnitude of the
gain or loss that results from a particular
exchange rate change is FX Gain (Loss) Stn
- St Exposure Exposure is expressed in
units of the underlying host currency, the
exchange rate is the price of the host currency
in units of home currency (i.e. /FC), and hence
the exchange rate gain/loss is in home currency
units.
3
Foreign Exchange Exposure

• There are three important kinds of exposure
• Translation Exposure (or Accounting Exposure)
• Transaction Exposure (or Contractual Exposure)
• Economic Exposure (or Operating Exposure)
• Although we shall see that economic exposure is
  most important measure, firms are concerned with
  all three.
• Hence, each measure is worth understanding.

4
Translation Exposure
Translation exposure is relevant to the
preparation of the parent companys financial
statements, where a firms foreign
currency-denominated accounts on the balance
sheet are affected by exchange rate
changes. Translation exposure is currently
defined for U.S. firms by the Financial
Accounting Standards Board (FASB) in Statement
No. 52 - called FASB-52, which quantifies
translation exposure as the difference between
total assets and total liabilities. Hence, to
determine the foreign exchange gain or loss, the
net asset position (assets minus liabilities) is
used as the measurement of exposure.
5
Summary of Translation Exposure
Step 1 Determine functional currency
6
Summary of Translation Exposure
Step 1 Determine functional currency
Host currency
Step 2 Translate using current method -
recording gains/losses in the balance sheet as
unrealized.
7
Summary of Translation Exposure
Step 1 Determine functional currency
Host currency
Home currency
Step 2 Translate using temporal method -
recording gains/losses in the income statement as
realized.
Step 2 Translate using current method -
recording gains/losses in the balance sheet as
unrealized.
8
Summary of Translation Exposure
Step 1 Determine functional currency
Host currency
Home currency
Step 2 Translate using temporal method -
recording gains/losses in the income statement as
realized.
Step 2 Translate using current method -
recording gains/losses in the balance sheet as
unrealized.
Step 3 Consolidate into parent companys
financial statements.
9
Transaction Exposure
Transaction exposure is the degree to which cash
and transactions denominated in a foreign
currency and already entered into for settlement
at a future date are affected by exchange rate
changes. Transaction exposure measures net cash
and known cash inflows against known cash
outflows.
10
Economic Exposure
Translation (or accounting) measures of exposure
are based on changes in book values of foreign
currency assets and liabilities. Since the value
of a firm is equal to the present value of future
cash flows, translation exposure - while
necessary for consolidating subsidiary and parent
financial statements - usually has no bearing on
the firms valuation. Economic exposure measures
the effects of exchange rate changes on a firms
operating cash flows and, thereby, its market
value.
11
Economic Exposure

• Economic exposure integrates three key aspects of
  exchange rate risk
• Cash flow exposure the impact of exchange rate
  changes on the future operations of a firm - how
  costs and revenues denominated in different
  currencies fluctuate.
• 2. Net worth exposure the impact of exchange
  rate changes on the market values of fixed
  assets and inventory.
• 3. Real exchange risk accounting for exchange
  rate changes that result from differences in
  national inflation rates.

12
Economic Exposure
Why real exchange rate changes? Relative price
changes ultimately determine a firms long-run
exposure to currency change. Currency changes -
particularly those of high-inflation currencies -
are usually preceded by or accompanied by
changes in relative price levels between two
countries. Hence, it is impossible to determine
exposure to a given currency without considering
simultaneously the offsetting effects of these
price changes. Alternatively, exchange rates
often affect firms most severely when the nominal
exchange rate does not move at all - when
relative price changes are not being offset by
exchange rate adjustments.
13
Cash Flow Exposure
Cash flow exposure evaluates the ongoing cash
flows of the firm. These cash flows are
evaluated from a real standpoint - they are
adjusted for inflation. Therefore, cash flow
exposure (also know as income statement exposure
or real operating exposure) is the extent to
which a firms real revenues and expenses are
affected by exchange rate changes. The sectors of
the economy in which the firm operates, the
sources of the firms inputs, and fluctuations in
real exchange rates delineate the firms true
economic exposure.
14
Net Worth Exposure
The second component of economic exposure is net
worth exposure - also know as economic balance
sheet exposure. Net worth exposure is the extent
to which a companys real net asset position -
the market value of assets net of the market
value of liabilities - is affected by exchange
rate changes. We will consider non-monetary
assets and liabilities first.
15
Non-Monetary Assets and Liabilities
Lets take the example of an Australian subsidiary
facing a depreciation of the Australian
dollar. Since the market value of non-monetary
assets - such as property, plant, equipment, and
inventory - will likely rise with local
inflation, they will only be exposed to the
extent that there is a real devaluation of the
Australian dollar. In other words, the
subsidiarys real estate will be worth less in
real (inflation-adjusted) U.S. dollars only if
the Australian dollar has fallen more than the
inflation differential.
16
Non-Monetary Assets and Liabilities
Here the distinction between anticipated and
unanticipated real exchange rate changes becomes
important. Why? The law of one price Countries
with currencies expected to depreciate in real
terms will have depressed prices of non-monetary
assets - prices which anticipate the currencys
real depreciation.
17
Monetary Assets and Liabilities
Monetary assets and liabilities will be exposed
to real exchange rate changes as well. Monetary
assets and liabilities carry nominal returns
determined by the relevant interest rate. Hence,
any real depreciation will reduce the
home-currency net asset position as long as the
real depreciation is not offset by changes in the
interest rate. Again, any real depreciations that
are anticipated will be reflected in the interest
rates. Hence, because net worth exposure
focuses on market values in the determination of
the real net asset position, a firms net worth
is exposed only to the extent that there are
unanticipated real exchange rate changes.
18
Measuring Economic Exposure
A statistical measure of economic exposure can be
obtained by applying linear regression analysis
to cash flows or real net asset values. For cash
flow exposure, a regression of the following type
can be estimated CFt a b st ut, where
CFt denotes cash flows in home currency units in
period t and st is the spot exchange rate in
terms of home currency units per foreign currency
unit. The estimated coefficient b, will be b
Cov(CFt st) / Var(st)
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Measuring Economic Exposure
b Cov(CFt st) / Var(st) Hence, b will
measure the sensitivity of cash flows to the
level of the exchange rate - which is precisely
exposure denominated in the foreign currency
units. Example. The R2 statistic from the
regression will measure the fraction of cash flow
variability that can be explained by changes in
the exchange rate. The regression should be run
in real terms. - The cash flows should be
deflated by the home currency inflation (i.e.
converted into constant 1980 dollars). - The
exchange rate should be the real exchange rate.
20
Measuring Economic Exposure
What happens if the regression is run in nominal
terms? As an example, consider the case where the
Pound-Dollar real exchange rate is constant. If
inflation is 10 in the U.S. per year and zero in
the U.K., the dollar must be depreciating by 10
per year to maintain the constant real exchange
rate. If a nominal regression is run, however,
dollar cash flows will be increasing at 10 per
year and the spot exchange rate will be rising at
10 per year reflecting the nominal depreciation
of the dollar. b will pick up the fact that each
side of the regression is increasing at 10 per
year - which will be misattributed to
exposure. Run in real terms, the regression
correctly delivers b 0.
21
Measuring Economic Exposure
This measurement technique can be applied in many
different ways - regressing net asset value on
exchange rate to determine net worth
exposure. - regressing total market value,
recovered from the stock price, onto exchange
rate changes. - including lagged values of the
exchange rate in the regression if an
adjustment lag in cash flows might exist.
22
Example American Airlines
Bilson (1994) ran a regression to determine the
economic exposure of American Airlines. He
regressed the monthly price of American Airlines
stock (from January 1985 to December 1991)
on - the /Mark exchange rate (since over 75 of
AMRs revenues outside of the U.S. came from
Europe). - the price of oil (since this directly
influences costs). - the overall performance of
the U.S. stockmarket. The regression was run in
log-scale - so coefficients can be interpreted as
elasticities (i.e. if the coefficient on oil is
5, a 1 change in oil will result in a 5 change
in price).
23
Example American Airlines
The regression equation of the price of AMR stock
was as follows (with standard errors in
parentheses) ln PAMR - 3.5396 0.9829 ln
PSP - 0.1793 ln POIL - 0.7753 ln S/DM
(.9471) (.1107) (.0716)
(.1617) R2 0.53
where ln PAMR is the log of AMR stock ln PSP
is the log of the SP 500 index ln POIL is the
log of the price of crude oil futures ln S/DM
is the log of the /DM exchange rate
24
Example American Airlines
The coefficients on the SP 500 and oil futures
came in as expected. When the SP rises, so does
AMR. When the price of oil increases, the price
of AMR stock falls. The negative coefficient on
the /DM exchange rate implies that American
airlines is hurt by a dollar depreciation. A one
percent increase in the Mark is associated with a
0.77 percent decline in the stock price.
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MANAGING OPERATING EXPOSURE

• Operating exposure management requires long-term
  operating adjustments.
• A. Real v. Nominal Changes
• 1. Relative price changes leads to marketing
  and/or production revisions
• B. Proactive Marketing and Production
  Initiatives
• 1. Market selection -- 3Ps
• 2. Productionproduct sourcing, input mix,
  plant location, raising productivity

26
Product Management Adjustments

• Product sourcing and plant location are the main
  variables that can be manipulated.
• A. Input mix
• B. Shift production among plants
• C. Plant location
• D. Raising productivity

27
Financial Managers Role in Marketing and
Production

• A. Provide local manager with forecasts of
  inflation and exchange-rate changes.
• B. Identify and focus on competitive exposure.
• C. Design the evaluation criteria so that
  operating managers neither rewarded or penalized
  for unexpected exchange-rate changes.
• D. Estimate and hedge the operating exposure
  after adjustments made.

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Summary of Economic Exposure
1. Economic exposure, rather than focusing on the
translation of financial statements or exposure
of immediate-term finances, measures the extent
to which a firms market value changes with
exchange rates. 2. Economic exposure integrates 3
key aspects of exchange rate risk cash flow
exposure, net worth exposure, and real exchange
rate risk. 3. Real exchange rate changes must be
used to distinguish between exchange rate
fluctuations that simply offset inflation
differentials and changes that impact a
subsidiarys real home-currency
value. 4. Exchange rate risk can be highly
pronounced in firms with purely domestic
operations and firms operating in countries with
fixed nominal exchange rates.
29
Summary of Economic Exposure
5. Cash flow exposure measures the extent to
which a firms real revenues and expenses -
absent depreciation and debt repayment - are
affected by exchange rate changes. 6. Microeconomi
c theory is useful in the analysis of cash flow
exposure as it allows us to distinguish between
price, volume, and margin effects on overall firm
profit. 7. When there are no deviations from RPPP
or when the subsidiary is operating in world
markets for inputs and outputs, its cash flows
are not exposed to exchange rate
fluctuations. 8. If a subsidiary is entirely
self-contained, only profits shrink or expand
with real exchange rate changes - there are no
volume or host-country price effects.
30
Summary of Economic Exposure
9. When operating in a world output market in the
currency of the parent, costs move with real
exchange rate fluctuations, while marginal
revenues remain constant. 10. If the firm is a
price-taker, output, margin, and profits expand
with a real depreciation. If the firm has an
impact on prices, the decline in costs will be
passed-through to the consumer in the form of
lower prices, though margin, output, and profits
continue to be higher. 11. When operating in a
world input market in the currency of the parent,
revenues will move with real exchange rate
changes, while costs remain constant.
31
Summary of Economic Exposure
12. If the firm is a price-taker, output, margin,
and profits decline with a real depreciation. If
the firm has an impact on prices, the decline in
home-currency marginal revenue will be
passed-through in the form of higher local
currency prices, though home-currency prices,
output, margin, and profits will all be
lower. 13. In world markets for inputs or
outputs, a firm must worry about the currency
habitat of price - the currency or basket of
currencies in which the price of the input or
output has the least variability. 14. Focusing on
the currency habitat of price allows the firm to
distinguish between price risk (which is a
function of supply and demand conditions) and
exchange rate risk.
32
Summary of Economic Exposure
15. If the currency habitat of price is in a
currency different from the parent companys
currency, the firm must worry also about currency
fluctuations with respect to this third currency
(or basket of currencies). 16. Net worth exposure
measures the extent to which a companys real net
asset position - the market value of assets and
liabilities - is affected by exchange rate
changes. 17. Since prices for assets and
liabilities are forward-looking, while prices for
inputs or outputs are not, real exchange rate
expectations are important. 18. Non-monetary
assets and liabilities will have expected real
exchange rate changes built into prices.
33
Summary of Economic Exposure
19. Monetary assets and liabilities will have
real exchange rate expectations built into
interest rates. 20. Hence, net worth is only
exposed to unanticipated changes in real exchange
rates. 20. Economic exposure can be measured
using linear regression - regressing cash flows,
net worth, or stock prices on exchange rates.
21. If conducted in levels, the slope
coefficient can be interpreted as the exposure
measure. Exchange rate changes times this
exposure yield the exchange rate
gain/loss. 22. If conducted in logs, the slope
can be interpreted as an elasticity - a 1 change
in exchange rates yields an x change in cash
flows, net worth, etc.
34
Summary of Economic Exposure
23. The regression must be run in real terms -
real exchange rates and inflation-adjusted cash
flows. 24. The R-square can be interpreted as the
fraction of cash flow, net worth, or stock price
fluctuation that can be accounted for by exchange
rate changes.
35
Cash Flow Exposure
We begin by considering cases where the
subsidiary is a price-taker. We will consider
5 basic cases Case 1 No deviations from
RPPP. Case 2 Real exchange rate changes and a
self-contained subsidiary. Case 3 Real
exchange rate changes and a world output
market. Case 4 Real exchange rate changes and
a world input market. Case 5 Real exchange
rate changes and world output and input markets.
36
Case 1 No Deviations from RPPP
If RPPP holds, nominal exchange rate changes
correspond to inflation differentials and there
are no real exchange rate changes. The
depreciation of the host currency is solely the
result of higher inflation in the host than in
the home country. How does this effect the
companys home currency revenues? 1. The host
price of the product will rise with
inflation. 2. Since the host currency has
depreciated against the home currency, the price
will not rise as much when converted the home
currency.
37
Case 1 No Deviations from RPPP (cont.)
3. Since RPPP holds, the rise in the home
currency price will exactly correspond to home
currency inflation. 4. Hence, the real home
currency price of the product will remain
unchanged. If RPPP holds, the depreciation has no
real effect on the subsidiary home currency
revenues. The same analysis will hold for
production costs.
38
Case 2 Self-Contained Subsidiary
Consider the case where the subsidiary is
entirely self-contained - it services only the
local market and undertakes all production in the
local market. Now, however, we allow there to be
changes in the real value of the host
currency. Recall from microeconomics the usual
case of a firm functioning in a competitive local
environment
39
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

Quantity of output on the x-axis
q
40
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

U.S. dollars - since this is what the parent is
concerned with - on the y-axis
q
41
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
The firm faces an upward-sloping marginal cost
curve.
q
42
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
Each successive unit of output costs more to
produce than the previous.
q
43
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
MR P
Since the firm is a price-taker, Marginal Revenue
will be a flat line equal to price.
q
44
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
MR P
The marginal revenue from each unit of additional
output will simply equal the price at which it is
sold.
q
45
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
MR
The profit-maximizing firm will set output where
marginal cost equals marginal revenue
q0
q
46
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
MR
where the revenue on the last unit of output
exactly equals its cost of production.
q0
q
47
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
AC
MR
To determine the firms margin, we draw the
average cost curve.
q0
q
48
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
AC
MR
Average costs will decline when marginal costs
are lower than average costs...
q0
q
49
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
AC
MR
then average costs will rise when marginal costs
become higher than average costs.
q0
q
50
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
AC
MR
Average costs are at a minimum - and flat - when
they equal marginal costs...
q0
q
51
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
AC
MR
average costs do not change when an additional
unit of output is produced - since its
incremental cost is the same as the average.
q0
q
52
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
AC
MR
The firms profit margin - profit per unit sold -
will then be the difference between revenues and
average costs.
q0
q
53
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
AC
MR
Profits will thus equal margin times quantity -
or the shaded area.
q0
q
54
Case 2 Self-Contained Subsidiary
Recall from microeconomics the usual case of a
firm functioning in a competitive local
environment

MC
AC
MR
Profits will thus equal margin times quantity -
or the shaded area.
q0
q
55
Case 2 Self-Contained Subsidiary
How is the self-contained subsidiary affected by
changes in the real exchange rate? If the host
currency depreciates in real terms 1. All curves
shift downward by the same proportion. 2. Output
volume remains unchanged. 3. Real dollar costs
and revenues are reduced proportionately. 4. Si
nce costs are lower than revenues, their
difference - the profit margin - must also fall
proportionately.
56
Case 3 World Output Market
Now consider a subsidiary whose input costs are
entirely denominated in the host currency, but
whose output is priced according to world supply
and demand conditions. For now, consider a
product price is determined in the home currency
and is invariant to changes in the value of the
home currency. Hence, changes in the value of the
host currency will not affect the subsidiarys
real home currency marginal revenue schedule. The
changes will, however, affect the marginal cost
schedule as before.
57
Case 3 World Output Market (cont.)
2. The subsidiary expands production - since the
host country is now the low-cost producer of the
product. 3. The profit margin has also increased,
since the average costs shift down. 4. The
firm is unambiguously better off with the
depreciation as output, margin, and total
profits are higher.
58
Case 4 World Input Market
Now consider a subsidiary whose inputs are
primarily imported and priced in the home
currency, whereas the output market is priced in
in the host currency. Now, the marginal revenue
line will shift up or down with real fluctuations
in the home currency, while home currency-based
marginal costs remain constant. The profit
margin declines. The firm cuts back production
in order to reduce costs. The reduction of
margin and output results in considerable
reduction in firm profits.
59
Case 5 World Input and Output Markets
What will be the impact of exchange rate changes
when the subsidiary is competing in a world
market for its output and producing this output
with factors supplied in a world input
market? Zero. Marginal costs and marginal
revenues are not shifting with real changes in
the host currency.
60
What if the Firm is not a Price-Taker?
How does the analysis change if the firm is not
operating in a competitive market? Consider the
case where a firms output is a significant
portion of the total market and hence the firm
has an impact on prices. Specifically, if this
firm increases its output, the price that it
receives for its products will necessarily
fall. In this case, the company will have some
freedom to adjust its local price - via changes
in output - in response to exchange rate
changes. This concept is know as exchange rate
pass-through.
61
Exchange Rate Pass-Through
When a firm operates in an environment that is
not competitive

MC
P
Now, since firm output has an impact on price,
the effective price line is downward-sloping.
MR
q
62
Exchange Rate Pass-Through
When a firm operates in an environment that is
not competitive

MC
P
The marginal revenue curve has a steeper slope...
MR
q
63
Exchange Rate Pass-Through
When a firm operates in an environment that is
not competitive

MC
P
since each additional unit of output is not only
sold for a lower price - it also is lowering the
price at which all other units are sold.
MR
q
64
Exchange Rate Pass-Through
When a firm operates in an environment that is
not competitive

MC
P
Once again, output will equate marginal revenue
with marginal cost.
MR
q0
q
65
Exchange Rate Pass-Through
When a firm operates in an environment that is
not competitive
Margin is the difference between sale price and
average cost.

MC
P
AC
MR
q0
q
66
Exchange Rate Pass-Through
When a firm operates in an environment that is
not competitive

And profits will be margin times output.
MC
P
AC
MR
q0
q
67
Exchange Rate Pass-Through
How does a decline in the hosts real exchange
rate affect a firm operating in an environment
that is not competitive? If the subsidiary is
self-contained? - Host currency prices are
unchanged. - output remains unchanged. - Home
currency prices and profits are lower. If the
subsidiary is in a world output market? - prices
are reduced. - output is increased. - profits
are higher.
68
Exchange Rate Pass-Through
If the subsidiary is in a world input market? -
output is lower. - Home currency prices are
increased. - Home currency profits are reduced.
69
The Currency Habitat of Price
Our analysis requires determining which currency
is important for the determination of the price
for inputs or product. The issue essentially
boils down to determining which currency the
price for a particular input or product is most
stable. This will generally be the currency in
which much of production or sales of the product
take place. An input or output prices most
stable currency is called its currency habitat
of price - or its currency of determination.
70
The Currency Habitat of Price
What is the currency habitat of - Oil - RAM
chips - Automobiles - Finance professors -
Wine - Tourism It may be helpful to think of a
prices currency habitat as actually a basket of
currencies. For example, the price of wine will
likely have the lowest variability in a basket
which includes the Dollar, Franc, and Lira.
71
The Currency Habitat of Price
One point to keep in mind is that the preceding
analysis of cash flow exposure considered (for
simplicity) world markets for input and output to
have a currency habitat of price in the home
currency. This simplified the treatment since the
parent company was based in the home country and
therefore concerned with the value of cash flows
in the home currency. If the currency habitat of
price is actually in a third currency, shifts in
marginal cost or revenue curves due to
fluctuations in this currency must be recognized
in the analysis.