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ECONOMIC EXPOSURE

ECONOMIC EXPOSURE. Agenda. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES IDENTIFYING ECONOMIC EXPOSURE. CONCEPT OF FOREIGN EXCHANGE EXPOSURE. Economic exposure focuses on the impact of currency fluctuations on the firm’s value.

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ECONOMIC EXPOSURE

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  1. ECONOMIC EXPOSURE Presenter: Van Phan

  2. Agenda • FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE • THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES • IDENTIFYING ECONOMIC EXPOSURE Presenter: Van Phan

  3. CONCEPT OF FOREIGN EXCHANGE EXPOSURE Economic exposure focuses on the impact of currency fluctuations on the firm’s value. • Expectations about fluctuations must be incorporated in all basic decisions of the firm. • Definitions: • Accounting exposure: impact on firm’s balance sheet • Economic exposure • Cash Flow exposure • Net worth exposure Presenter: Van Phan

  4. Definition • Economic Exposure: The risk that exchange rate changes may affect the present value of future income streams. Presenter: Van Phan

  5. Case 1: No Deviation From PPP • An example of a U.S corporation’s British Subsidiary • Assumption: PPP holds • Nominal ER=  - * = S • Domestic inflation less foreign inflation should equal the change in the spot rate. • Implies that the higher inflation country should see its currency depreciate.= depreciation of £ is the result of higher inflation in UK than in U.S Presenter: Van Phan

  6. No Deviation From PPP • £ price of the product will rise in accordance with British inflation • Results • $price • $ AC • $ margin No change • Volume • Profit Presenter: Van Phan

  7. Case 2: Real ER changes and self-contained subsidiary-Price-Taker • Perfectly competitive market • British operation services the local market and undertakes all production locally • £ depreciates in real term • £ Price: not change: price taker • $ Price: change • $ Costs: change • $ Profit margin: Decline in proportion of ER change Presenter: Van Phan

  8. Real ER changes and self-contained subsidiary-Price-Taker $ MC AC MR Po MR’ P1 Co C1 Q0 Quantity Presenter: Van Phan

  9. Real ER changes and self-contained subsidiary-Price-Maker • The result is the same: Why • £ denominated demand curve: no change with the depreciation of £ • $ equivalent demand curse shift down • £ Price: not change: no change in D • $ Price: change • $ Costs: change • $ Profit margin: Decline in proportion of ER change Presenter: Van Phan

  10. Case 3: Real ER and a World Output Market • Assumption: • British subsidiary functions in a world market for output • The world price is determined in $ (MR=MR’) • Results of £ depreciation • Change the cost structure because of the local inputs • Increase the production = Increase profit Presenter: Van Phan

  11. Real ER and a World Output Market MC’ $ MC AC AC’ MR=MR’ Po Co C1 Quantity Q0 Q1 Presenter: Van Phan

  12. Case 4: Real ER and a World Input Market • Assumption: • Output is priced in £ • Input is priced in $ (MR=MR’) • Results of £ depreciation • Shift the $MR down • Cost function does not shift down = cut production to reduce costs= profit declines Presenter: Van Phan

  13. Case 5: Real ER and a World Input & Output Market • Assumption • Competing in a world of output • Producing the output with factors supplied in a world input market • Results of £ depreciation • No shift the $MR • No shift the cost function= no economic exposure Presenter: Van Phan

  14. ConclusionLocal Currency Depreciation Presenter: Van Phan

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