Measuring and Managing Economic Exposure

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CHAPTER 11

• Measuring and Managing Economic Exposure

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PART I. FOREIGN EXCHANGE RISK AND ECONOMIC
EXPOSURE

• I. FOREIGN EXCHANGE RISK
• A. Economic exposure
• focuses on the impact of currency
• fluctuations on firms value.
• 1 . The most important aspect of foreign
  exchange risk management
• Incorporate expectations about the risk
  into all basic decisions of the firm.

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• 2. Definition
• Economic exposure
• Transaction exposure
• Operating exposure
• arises because currency fluctuations
  alter a companys future revenues and expenses.

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• To measure operating exposure requires a
  longer-term perspective.
• i.e. Cost and price competitiveness could
  be affected by exchange rate changes

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• Operating Exposure begins
• the moment a firm starts to invest in a market
  subject to foreign competition or in sourcing
  goods or inputs abroad

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• The new investment includes
• New product development
• A distribution network
• Brand name development
• Marketing
• Foreign supply contracts
• Production facilities

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• B. Real Exchange Rates Changes and Risk
• Nominal v. real exchange rates
• real rate has been adjusted for
• price changes.

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• C. Implications
• 1. If nominal rates change with an equal
  price change, no alteration to cash
  flows.
• 2. If real rates change, it causes relative
  price changes and changes in
  purchasing power.

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• A decline in the real value of a currency
• makes exports and import-competing goods more
  competitive
• An appreciating currency makes
• imports and export-competing goods more
  competitive

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• During an appreciation of home currencies
• Exporters face two choices
• 1 keep prices constant (but lose sales)
• or
• 2 adjust prices to foreign currency to
  maintain market share (lose profits)

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• 3. SUMMARY
• a. the economic impact of a currency
  change depends on the offset by the difference
  in inflation rates or the change in real
  exchange rates.
• b. It is the relative price changes that
  ultimately determine a firms long-run
  exposure.

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PART II. THE ECONOMIC CONSEQUENCES OF EXCHANGE
RATE CHANGES

• I. ECONOMIC CONSEQUENCES
• The impact on Operating Exposure of a real
  rate change depends upon
• Pricing flexibility and
• 1. Price elasticity of demand 2. Degree of
  product differentiation
• 3. The Ability to shift production and
• the substitution of inputs

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If HC Appreciates

Pricing Flexibility is key
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If HC Appreciates

• Can the firm maintain its profit margins both at
  home and abroad?
• If price elasticity of demand is low, the more
  price flexibility a firm has.
• i.e. Availability of good substitutes

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If HC Appreciates

• Product Differentiation
• price elasticity depends on degree of
  differentiation
• The greater the differentiation, the more the
  firm can control its prices.
• e.g. Mercedes Benz cars

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If HC Appreciates

• The Ability to Shift Production and to source
  inputs from other countries
• e.g. Japanese car makers in the late 1980s

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PART II.MANAGING OPERATING EXPOSURE

• I. INTRODUCTION
• Operating exposure management requires long-term
  operating adjustments and the involvement of all
  departments.

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MANAGING OPERATING EXPOSURE

• II. Marketing Strategy
• A. Market Selection
• use competitive advantage to carve
  out market share when currency
  values change

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MANAGING OPERATING EXPOSURE

• B. Pricing strategy Expectations critical
• 1. If HC depreciates, exporter gains
• competitive advantage by increasing unit
  profitability or market share.
• 2. The higher price elasticity of demand,
  the more currency risk
• the firm faces by other product
  substitution.

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MANAGING OPERATING EXPOSURE

• C. Product Strategy
• exchange rate changes may alter
• 1. The timing of new product introductions,
• 2. Product deletion
• 3. Product innovations

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MANAGING OPERATING EXPOSURE

• III. Product Management Adjustments
• A. Input mix shop the world
• B. Shift production among plants
• C. Plant relocation
• D. Raising productivity

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MANAGING OPERATING EXPOSURE

• IV. Planning For Exchange-Rate Changes
• A. Develop contingency plans
• with plausible scenarios
• before the impact of a currency change
  makes itself felt.
• e.g. flexible mfg systems

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MANAGING OPERATING EXPOSURE

• V. Financial Management of Exchange Rate
  Risk
• Financial managers Role
• Structure the firms liabilities in such a way
  that the reduction in asset earnings is matched
  by corresponding decrease in cost of servicing
  liabilities.

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MANAGING OPERATING EXPOSURE

• A. Provide local manager with
• forecasts of inflation and exchange-rate
  changes.
• B. Identify and focus on competitive exposure.

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MANAGING OPERATING EXPOSURE

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