Lecture 7

1. Lecture 7 Measuring and Managing Real Exchange Risk Chapter 9

2. Economic Exposure Economic exposure / Operating exposure / Real Exchange Risk: • the degree to which currency fluctuations can alter a firm’s future revenues and costs, that is, its operating cash flows. • Even if a firm prices all contracts in dollars or otherwise hedges its transaction exposure, the residual exposure – operating exposure – remains. • Operating Exposure  Longer-term perspective, Firm viewed as ongoing concern with operations whose cost & price competitiveness affected by exchange rate changes.

3. Economic Exposure • Arises from exchange-rate induced changes in a firm’s non-contractual or unplanned domestic and foreign cash flows • Relates to how exchange rate changes affect sales in domestic and foreign markets, as well as input costs (foreign or domestic sourced). • i.e changes in future earning power & competitiveness as a result of changes in exchange rates • Economic exposure relates to exchange-rate induced changes in a firm’s competitive position;  related to changes in real exchange rather than nominal exchange rate.

4. Importance of Real Exchange Rate • A dramatic change in the normal exchange rate will have no effects on the relative competitive positions of domestic firms and their foreign competitor --- if it is accompanied by an equal change in the price level! • The economic impact of a currency change on a firm depends on whether the exchange rate change if fully offset by the difference in inflation or whether the real exchange rate change. • We need to focus on changes in the purchasing power of one currency relative to another rather than the nominal exchange rate changes

5. Economic Exposure Real exchange risk (Operating exposure or economic exposure): • The phenomenon whereby the profitability of the firm can change because of fluctuations in the real exchange rate. • The variability in the PV of firm’s profits that is caused by unpredictable changes in the real exchange rate. • If changes in real exchange rates affect changes in firm’s cash flows either through changes in demand for its product or changes in its costs of its inputs → real exchange risk.

6. (1 + if)t et’ =et (1 +ih)t Foreign Exchange Risk and Economic Exposure • Real exchange rate = the nominal exchange rate adjusted for changes in the relative purchasing power of each currency since a base period. We compute the real exchange rate as et(D/F) • Example: The Danish krone has devalued by 5% this year. Danish and U.S. inflation rates were 3% and 2%, respectively. The real exchange rate is computed as (1 + 0.03) = 0.96e0 0.95e0 (1 + 0.02) • In this case, the real exchange rate et’ is 96% of the nominal exchange rate e0. • *In base year,et = et’

7. et’ – e0 e0 Foreign Exchange Risk and Economic Exposure Δet’ = • The change in et’ is computed as • Example: The change in the Dkr/$ et’ is computed as 0.96e0 – e0 = -4% e0 • The implications for exchange risk between et’ and etare vastly different. • A change in et accompanied by an equal change in prices should not affect the relative competitive positions of domestic and foreign competitors and will thus not alter real cash flows. • When et’ = et, relative prices are equal and no operating exchange risk exists. • A change in et’affects relative price changes – a reduction in the purchasing power of one currency relative to another – which will alter real cash flows.

8. At equilibrium E0, U.S. and Japan inflation both = 2% and change in e0 = 0 • U.S. inflation increases to 5% (ih – if = 3%),causing disequilibrium, or purchasing power disparity, at (0,3). • $/¥ exchange rate will rise ~3% (e1–e0 / e0 ≈ 3%) to equalize the dollar prices of goods in the two countries at a new equilibrium E1. Parity Line 5 4 3 2 1 E1 ih – if E0 -5 -4 -3 -2 -1 1 2 3 4 5 -1 -2 -3 -4 -5 e1 – e0 e0 Foreign Exchange Risk and Economic Exposure • Effects of inflation on exchange risk – Without relative price changes, that is, with no change in et’, an MNC faces no real operating exchange risk.

9. Foreign Exchange Risk and Economic Exposure • Example: • Compute and compare changes in the real and nominal values of the yen relative to the dollar (i.e., et and et’ = $/¥) from 1982 to 2006 • etin 1982 (e0 = base year) = $1/¥249.05, etin 2006 (e25) = $1/¥116.34 • CPIJapan in 1982 = 80.75, CPIJapan in 2006 = 97.72; if = 21% • CPIUS in 1982 = 56.06, CPIUS in 2006 = 117.07; ih = 109% (1 + 21%) e25’ = $1/¥116.34 =$.004981 (1 + 109%) • e0’ = $1/¥249.05 = $.004015. • Change in et’ = ($.004981 - $.004015) / $.004015 = 24%, meaning the yen appreciated 24% against the dollar in real terms – that is, the real dollar prices of Japanese exports rose by 24%.

10. Foreign Exchange Risk and Economic Exposure • Example, continued: • E.g., compute and compare the changes in the real and nominal values of the yen relative to the dollar from 1982 to 2006, continued • Change in et = (($1/¥116.34) – ($1/¥249.05)) / ($1/¥249.05) = 114%, meaning the nominal dollar prices of Japanese exports rose by 114% over the period. • Difference between et and et’ = 114% - 24% = 90%. • Conclusion: Inflation differentials justify only a 90% rise in et . Thus, the increase in et’ causes a deviation from PPP by 24%.

11. e25 – e0 e0 Foreign Exchange Risk and Economic Exposure • With relative price changes, that is, a change in et’ (and a deviation from PPP) an MNC faces real operating exchange risk. Graphical depiction of example: Parity Line Japan’s relative prices have risen by 24% over the period, creating real operating exchange or inflation risk for companies selling yen-denominated goods and services e25 114% 24% Inflation justifies only a 90% rise in e25 e25’ ih – if E0 88%

12. Foreign Exchange Risk and Economic Exposure • Example: An appreciation in the real value of the yen makes Japanese television exports less competitive by acting like a tax. • e0= ¥240/$, e10 = ¥90/$; U.S. inflation not in line with yen appreciation; cost per television over period = ¥100,000. • Year 0: Break-even dollar price = $417 (¥100,000/¥240) • Year 10: Break-even dollar price = $1,111 (¥100,000/¥90) • Dilemma: • Raising dollar prices results in lost sales because U.S. prices have not risen. • Maintaining dollar prices means cutting yen prices to ¥37,530 (417 * 90).

13. Foreign exchange risk and economic exposure • Example: A depreciation in the real value of the peso makes Mexican exports more competitive by acting like a subsidy. • As the peso depreciates, the dollar value of Mexican exports increases, while peso-denominated costs stay constant, increasing revenues and profits. • The economic impact of a currency change on a firm depends on whether the exchange rate change is fully offset by the inflation differential or whether et’, and thus relative prices, change.

14. Foreign Exchange Risk and Economic Exposure • Fixed exchange rates can create exchange risk. • Example: Brazil’s nominal exchange rate is fixed • e0 and e0’ = $0.50 • Brazil’s inflation over year = 100% but nominal rate does not change • e1 = $0.50, e1’ = $1.00 • Impact on a Brazilian shoe manufacturer’s profits is as follows: Costs double Profits decrease by two thirds *Reais is plural for the Brazilian currency real

15. Foreign Exchange Risk and Economic Exposure • Example, continued: Brazil’s nominal exchange rate is fixed • e0and e0’ = $0.50 • Inflation over year = 100% • e1= $0.50, e1’ = $1.00 • If shoe manufacturer raises prices to maintain profit margins, it loses competitiveness: Dollar price increases Profit margin preserved *Reais is plural for the Brazilian currency real

16. Economic Exposure • Economic exposure arises because the firm’s revenues and expenditures vary with movements in the real exchange rate • Real appreciation of foreign currency (real depreciation of domestic currency)  competitiveness of foreign goods  competitiveness of domestic goods • Real appreciation of domestic currency (real depreciation of foreign currency)  competitiveness of domestic goods  competitiveness of foreign goods

17. Economic Exposure • Economic exposure cannot, in general, be known accurately in advance. • It can be estimated from a regression equation relating changes in cash flows to changes in exchange rates. • Overall impact on firm of exchange rate changes depends not only how firm reacts, but also on how the firm’s competitors, customers, and suppliers react.

18. Economic Exposure

19. Economic Exposure • If changes in real exchange rates affect changes in firm’s cash flows either through changes in demand for its product or changes in its costs of its inputs → real exchange risk. • In general, a real depreciation of the domestic currency hurts importing firms and helps exporting firms. • Real depreciation of domestic currency makes domestic exporters and import competitors more profitable because it shifts demand to the domestic market.

20. Economic Exposure • The Real Exchange Rate Risk of a Net Exporter • Real appreciation of domestic currency (real depreciation of foreign currency)  dilemma. • If domestic net exporter does not increase its price in foreign market, the domestic currency value of its revenue will decrease. • If net exporter increases its prices, the net exporter’s sales in the foreign market will decline. • Either way, though, a real depreciation of foreign currency hurts domestic net exporter’s real profitability.

21. Economic Exposure Major Factor that Determines a Firm’s Response: Price elasticity of demand for its product. • The more inelastic a product’s demand curve, the less the quantity of it sold falls when its price rises  drop-off in sales will be relatively little. • The more elastic a product’s demand curve, the more the quantity sold will fall when the product’s price rises.  the more likely it is that consumers will switch products or not buy the product at all when the relative price increases.

22. Management of Economic Exposure • Economic exposure refers to the impact exchange rate fluctuations can have on a firm’s future cash flows. • Recall that corporate cash flows can be affected by exchange rate movements in ways not directly associated with foreign transactions. • Exchange rate changes are often linked to variability in real growth, inflation, interest rates, governmental actions,… If material, the changes may cause firms to adjust their financing and operating strategies.

23. Foreign Exchange Risk and Economic Exposure • Operating exposure • Real exchange rates affect numerous aspects of a firm’s operations. • Pricing flexibility – in light of a dollar appreciation, can the firm maintain its dollar margins in its domestic (to compete against lower-cost imports) and foreign markets? • Pricing flexibility is a function of price elasticity of demand (i.e., increases/ decreases in demand given changes in price). • The more sensitive consumers are to price changes, the more elastic their demand will be. • The more differentiated a product, the less competition it faces, and the less elastic the demand will be. The more commoditized, the greater competition it faces, and the more elastic the demand will be.

24. Foreign Exchange Risk and Economic Exposure • Operating exposure, continued • Real exchange rates affect numerous aspects of a firm’s operations, continued. • Ability to shift production and sourcing among countries – the greater a company’s flexibility to substitute between domestic and foreign inputs or production, the less exchange risk the company will face. • All else equal, firms with global production and purchasing networks can manage currency changes by increasing production and purchasing in a country whose currency has been devalued in real terms and decreasing production and purchasing in a country whose currency has been revalued in real terms. • While prices in the local currency cannot be increased to the full extent of the local currency devaluation (to increase the exchange value), its lower prices will be more competitive, offsetting some revenue declines.

25. Summary of economic effects of exchange rate changes

26. Management of Economic Exposure • A firm can assess its economic exposure by determining the sensitivity of its expenses and revenues to various possible exchange rate scenarios. • Hedging economic exposure invariably involves the restructuring of firm’s operations. • MNCs must be very confident about the long-term potential benefits before they proceed to restructure their operations, because of the high costs of reversal. • Depending on the underlying conditions, restructuring aimed at reducing economic exposure may involve initiatives such as:

27. Management of Economic Exposure • Increasing or reducing sales in new or existing foreign markets. • Increasing or reducing reliance on foreign suppliers of raw materials and other intermediate inputs. • Establishing or elimination of production facilities in foreign countries. • Increasing or reducing the level of foreign currency denominated debt.

28. Strategies for Managing Real Exchange Risk • Overview • Transitory Versus Permanent Changes in Real Exchange Rates • Production Management • Marketing Management

29. Strategies for Managing Real Exchange Risk • Transitory Versus Permanent Changes in Real Exchange Rates • Key element influencing a firm: length of time the exchange rate is expected to persist

30. Strategies for Managing Real Exchange Risk • Production Management • Production scheduling • Input sourcing • Plant location decisions

31. A Production Manager’s Responses to Real Exchange Rates

32. Strategies for Managing Real Exchange Risk • Marketing Management • Pricing policies • The frequency of price adjustments • Market entry decisions • Brand loyalty

33. A Checklist for Managers of Real Exchange Risk