Chapter 11 Managing Operating Exposure to Currency Risk

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Chapter 11Managing Operating Exposureto
Currency Risk
Learning objectives ? Operating exposure to
currency risk Exposure of real
assets Exposure of shareholders equity ?
Managing operating exposure Internal
hedges Financial market (external) hedges ?
Operating exposure to currency risk and the
firms pricing strategy
Butler, Multinational Finance, 4e
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Exposures to currency risk

• Economic exposure to currency risk
• Transaction exposure of monetary (contractual)
  assets and liabilities
• Operating exposure of real assets
• Equity exposure to currency risk
• Net monetary assets exposed to currency risk plus
  the operating exposure of real assets

Operating exposure
3
The law of one price revisited

• In an integrated market
• purchasing power parity holds so that equivalent
  assets trade for the same price regardless of
  where they are traded
• In a completely segmented market
• prices are locally determined
• Real-world markets fall somewhere between these
  extremes

Operating exposure
4
Operating exposures to fx risk
Revenues

Local
Global
Domestic firms
Exporters
Local
(0)
()
Operating expenses
Global MNCs importers/exporters in
globally competitive markets (?)
Importers
Global
(-)
Operating exposure
5
The exposure of shareholders equity

Operating exposure
6
The exposure of shareholders equity

Operating exposure
7
Market-based estimatesof currency risk exposure
rd/f
sd/f
sd/f

• rtd ad ßf std/f etd

Operating exposure
8
An exampleFord Motor Companys exposures

• rt m b st/ b st/ b st/
  et
• 0.060 0.02 st/ 0.01 st/ (-0.01)
  st/ et
• What is the expected return on Ford stock when
• st/ 10 st/ 8 st/ 8
• Ert 0.06 (0.02)(0.10) (0.01)(0.08)
  (-0.01)(0.08)
• 0. 062
• or 6.2 percent

Operating exposure
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Accounting-based estimates

• Sensitivities of revenues and expenses to foreign
  exchange rates
• revtd arevd brevf std/f etd (11.7)
• exptd aexpd bexpf std/f etd (11.8)

revd/f
expd/f
sd/f
sd/f
sd/f
sd/f
Operating exposure
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Managing operating exposure in the financial
markets

• An exporters hedging alternatives
• Sell the foreign currency with long-dated forward
  contracts
• Finance foreign projects with foreign debt
• Use currency swaps to acquire financial
  liabilities in the foreign currency
• Use a rolling hedge to repeatedly sell the
  foreign currency forward

Managing operating exposure
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Managing operating exposure in the financial
markets

• An importers hedging alternatives
• Buy the foreign currency with long-dated forward
  contracts
• Invest in long-dated foreign bonds
• Use currency swaps to acquire financial assets in
  the foreign currency
• Use a rolling hedge to repeatedly buy the foreign
  currency forward

Managing operating exposure
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Financial market hedgesof operating exposures

• Advantages
• Most financial market instruments are actively
  traded and liquid
• If financial prices reflect true value, then
  financial market transactions are zero-NPV
  transactions
• Disadvantage
• A financial market hedge provides an imperfect
  hedge of operating exposure to currency risk

Managing operating exposure
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Duracells operating exposure(in millions)

• Operating exposures are uncertain
• Underlying revenues in yen
• 50 100 150
• Cash flows of the forward hedge
• long dollars 1 1 1
• short yen 100 100 100
• Net position
• in dollars 1 1 1
• in yen 50 0 50
• Result of hedge Too much Just right Too little

Managing operating exposure
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Duracells operating exposure(in millions)

• Interaction of two sources of variability
• Underlying revenues in yen
• 50 50 50
• Cash flows of the forward hedge
• long dollars 1 1 1
• short yen 100 100 100
• Net position
• in dollars 1 1 1
• in yen 50 50 50
• Actual exchange rate 0.005/ 0.010/ 0.015/
• Actual revenues 0.75 0.50 0.25

Managing operating exposure
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Duracells operating exposure(in millions)

• Interaction of two sources of variability
• Underlying revenues in yen
• 150 150 150
• Cash flows of the forward hedge
• long dollars 1 1 1
• short yen 100 100 100
• Net position
• in dollars 1 1 1
• in yen 50 50 50
• Actual exchange rate 0.005/ 0.010/ 0.015/
• Actual revenues 1.25 1.50 1.75

Managing operating exposure
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Managing operating exposure through operations

• Take advantage of the MNCs ability to respond to
  differences in real exchange rates
• Plant location Gain access to low-cost labor or
  capital resources
• Product sourcing Shift production to countries
  with low real costs
• Market selection Shift marketing efforts toward
  countries with higher demand or overvalued
  currencies

Managing operating exposure
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Operating hedgesof operating exposures

• Advantages
• Operating hedges create a fundamental change in
  the way the MNC does business and thus a
  long-lasting change to the companys currency
  risk exposure
• With established international relations, the MNC
  is in a better position to take advantage of
  opportunities in international markets
• Disadvantage
• Operating hedges are seldom zero-NPV transactions

Managing operating exposure
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Pricing strategy in intl markets

• An example
• For the classic Japanese exporter, an
  appreciation of the euro increases the purchasing
  power of euro-zone customers
• Pricing alternatives include
• Hold the euro price constant
• Sell the same quantity at a bigger yen profit
  margin per unit
• Hold the yen price constant
• Lower the euro price and capture higher sales
  volume

Operating exposure and pricing strategy
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The price elasticity of demand

• Optimal pricing depends on the price elasticity
  of demand (DQ/Q)/(DP/P)
• Measures the sensitivity of quantity sold to a
  percentage change in price
• Price elastic demand - a small change in price
  results in a large change in quantity sold, so
  lower the price
• Price inelastic demand - a small change in price
  results in an even smaller change in quantity
  sold, so hold the price constant

Operating exposure and pricing strategy
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A Singapore exporters pricing strategy (25
appreciation from S2.00/ to S2.50/)

• 
  Maintain
  10 price
• 
  Sales
  volume
• Base
  case S2.00/ remains constant
• Income statement
  S
• Price per bottle 10 S20 10 S25
• Cost per bottle 5 S10 4 S10
• Bottles sold 2,000 2,000 2,000 2,000
• Revenues 20,000 S40,000 20,000 S50,000
• Cost of goods sold 10,000 20,000 8,000 20,0
  00
• Before-tax profit 10,000 20,000 12,000 30,000
• Tax (at 50) 5,000 10,000 6,000 15,000
• Net cash flow 5,000 10,000 6,000 15,000
• Value of Tao 50,000 S100,000 60,000 S150,000
• at i iS 10

Operating exposure and pricing strategy
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A Singapore exporters pricing strategy (25
appreciation from S2.00/ to S2.50/)

• 
  Maintain S20 price
  
• 
  Elastic demand Inelastic demand
• 
  Sell 50 more Sell 10 more
• Income statement
  S
• Price per bottle 8 S20 8 S20
• Cost per bottle 4 S10 4 S10
• Bottles sold 3,000 3,000 2,200 2,200
• Revenues 24,000 S60,000 17,600 S44,000
• Cost of goods sold 12,000 30,000 8,800 22,0
  00
• Before-tax profit 12,000 30,000 8,800 22,000
• Tax (at 50) 6,000 15,000 4,400 11,000
• Net cash flow 6,000 15,000 4,400 11,000
• Value of Tao 60,000 S150,000 44,000 S110,000
• at i iS 10

Operating exposure and pricing strategy
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Pricing strategyin international markets

• The optimal pricing strategy for this Japanese
  exporter depends on the price elasticity of
  demand for its products
• If demand is price elastic, then the firm is
  indifferent between maintaining the 10 price or
  maintaining the S20 price
• If demand is price inelastic, then the firm is
  better off maintaining the 10 price

Operating exposure and pricing strategy