Measuring and Managing Economic Exposure

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Measuring and Managing Economic Exposure

• (Shapiro Chapter 11)

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Measuring and Managing Economic Exposure

• Translation or accounting exposure is based on
  changes in reported financial cash flows based on
  changes in exchange rates
• Economic exposure is the change in the value of
  the firm (present value) based on changes in the
  exchange rate
• Based on changes in future cash flows (revenues,
  costs) owing to changes in exchange rates
• Difficult in that projection of changes in cash
  flows based on exchange rate changes have to be
  made
• This also includes changes in revenues and costs
  (based on the local currency) due to changes in
  exchange rates - has to do with relative inflation

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Operating Exposure Definition

• The effect of random changes in exchange rates on
  the firms competitive position, which is not
  readily measurable.
• A good definition of operating exposure is the
  extent to which the firms operating cash flows
  are affected by the exchange rate.

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Spectrum Manufacturing

• Spectrum Mfg. AB is the wholly owned Swedish
  affiliate of a U.S. multinational industrial
  plastics firm that manufactures sheet plastic in
  Sweden. 60 of its output is sold in Sweden with
  the rest exported to other countries in Europe.
  They use Swedish labor and both local and foreign
  raw materials. The corporate tax rate is 40 and
  the annual depreciation charge is SKr. 900,000.
  In addition, the firm has SKr. 3 million in debt
  with interest of 10.
• To begin with, the exchange rate is SKr 4 1
  which changes to SKr 5 1

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Spectrums Accounting Exposure

• Under the current rate method, Spectrum will have
  a translation loss of 685,000.
• Under the monetary/nonmonetary method Spectrum
  will have a much smaller loss of 50,000.

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Spectrums Operating (Economic) Exposure

• Three scenarios
• All variables remain the same.
• Krona sales prices and all costs rise volume
  remains the same.
• There are partial increases in prices, costs, and
  volume.

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Scenario 1 All variables remain the same
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Scenario 1 All variables remain the
same First-year cash flow (Skr 41)
900,000 First-year cash flow (Skr 51)
720,000 Net loss from devaluation
180,000
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Scenario 2 Krona sales prices and all costs
rise Volume remains the same
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Scenario 2 Sales and all costs rise First-year
cash flow (Skr 41) 900,000 First-year
cash flow (Skr 51) 891,000 Net loss
from devaluation 9,000
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Scenario 3 Partial increases in prices, costs,
and volume
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Scenario 3 Partial increases in prices, costs,
and volume First-year cash flow (Skr 41)
900,000 First-year cash flow (Skr 51)
1,010,800 Net gain from devaluation
110,800
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• Summary of case
• Measurement of economic impact of exchange rate
  change is non-trivial
• Quite different from translation exposure
• Regression approach
• Change in the cash flows
• a ß (change in exchange rate)
  error
• ?CFt a ß ?EXt error
• ? CFt CFt - CFt-1 and CFt is the
  dollar value of
• total affiliate (parent)
  cash flows in period t
• ? EXt EXt - EXt-1

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• Output measures
• ? Beta coefficient (b) 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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• Facing XR changes, a firm may choose one of
  these
• pass the cost shock fully to its selling prices
  (complete pass-through)
• fully absorb the shock and keep the prices
  unchanged (no pass-through)
• combination of the two

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Financial management of exchange rate risk

• Design financial policies so that exchange rate
  changes that reduce an assets earnings are
  matched by a decline in the firms liabilities
• Difficulty in implementation given the
  unpredictability of the cash flow changes when
  exchange rate changes

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Managing Operating Exposure

• Selecting Low Cost Production Sites
• Flexible Sourcing Policy
• Diversification of the Market
• RD and Product Differentiation
• Financial Hedging

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Selecting Low Cost Production Sites

• A firm may wish to diversify the location of
  their production sites to mitigate the effect of
  exchange rate movements.

• e.g. Honda built North American factories in
  response to a strong yen, but later found itself
  importing more cars from Japan due to a weak yen.

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Flexible Sourcing Policy

• Sourcing does not apply only to components, but
  also to guest workers.

• e.g. Japan Air Lines hired foreign crews to
  remain competitive in international routes in the
  face of a strong yen, but later contemplated a
  reverse strategy in the face of a weak yen and
  rising domestic unemployment.

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Diversification of the Market

• Selling in multiple markets to take advantage of
  economies of scale and diversification of
  exchange rate risk.

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RD and Product Differentiation

• Successful RD that allows for
• cost cutting
• enhanced productivity
• product differentiation.
• Successful product differentiation gives the firm
  less elastic demandwhich may translate into less
  exchange rate risk.

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Financial Hedging

• The goal is to stabilize the firms cash flows in
  the near term.
• Financial Hedging is distinct from operational
  hedging.
• Financial Hedging involves use of derivative
  securities such as currency swaps, futures,
  forwards, currency options, among others.