Measuring and Managing Economic Exposure

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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 firms 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 firms 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 Risk
• Nominal vs real exchange rates
• Real rate has been adjusted for price changes,
  and reflect the relative purchasing powers.
• Real rate changes may result in Hobsons Choice
  (We dont 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 firms 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 firms inputs
• Fluctuations in the real exchange rate
• delineate the firms true economic exposure.

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PART III.IDENTIFYING ECONOMIC EXPOSURE

• I. CASE STUDIES OF ECONOMIC EXPOSURE
• A. APEN SKIING COMPANY
• 1. Firms 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 firms exchange rate risk
• affected cost but not revenues.
• 2. Economic impact
• a. Revenues none ( pricing)
• b. Costs decreased
• c. Net effect increased US flows

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IDENTIFYING ECONOMIC EXPOSURE

• C. TOYOTA MOTOR COMPANY
• 1. Exchange rate risk affected BOTH
• revenues and costs.
• 2. Trying to decrease exposure may result in
  Flow back effect
• previously exported goods return
• with 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 RISK

• A workable approach can be
• Regression Analysis
• Variables
• changes in parents 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 EXPOSURE

• Operating 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 Selection
• use 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 Strategy
• exchange rate changes may alter
• 1. The timing of new product introductions/de
  letions
• 2. Product innovation
• (for decreasing elasticity)

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MANAGING OPERATING EXPOSURE

• III. Product Management Adjustments
• A. Input mix
• B. Shift production among plants
• C. Plant location
• D. 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

• Financial Management of Exchange Rate Risk
  Financial managers 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)