Measuring and Managing Economic Exposure

1. Measuring and Managing Economic Exposure Chapter 11

2. PART I.FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE • I. FOREIGN EXCHANGE RISK • Economic exposure focuses on theimpact of currency fluctuations onfirm’s value. • Changes in PV of the firm (long term) as a result of changes in the exchange rate • Expectations about the fluctuation must beincorporated in all decisions ofthe firm.

3. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE • Definitions: • a.Accounting exposure (past) • impact on firm’s balance sheet • b.Economic exposure • Transaction (contractual, present/future, short term) • Operating (future, longterm)

4. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE • Real Exchange Rates and Risk • Nominal vs real exchange rates • Real rate has been adjusted forprice changes, and reflect the relative purchasing powers. • Real rate changes may result inHobson’s Choice: (“We don’t likeeither choice!”) • When faced with a change in real value, • do you keep price constant (changing sales) • do you change prices (changeprofits)

5. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE • The economic impact of acurrency change depends on the offset by the difference in inflation rates or the real exchange rate. • It is the relative price changesthat ultimately determine a firm’s long-run exposure.

6. PART II.THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES • A. Transaction exposure • On-balance sheet (existingcontracts) • Off-balance sheet (contracts in the future, leases, loan repayments) • Assumption (flawed) • LC costs and revenues remain constant

7. 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

8. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES • II. SUMMARY • The sector of the economy in which the firm operates; • The sources of the firm’s inputs; • Fluctuations in the real exchange rate • delineate the firm’s true economic exposure.

9. PART III.IDENTIFYING ECONOMIC EXPOSURE • I. CASE STUDIES OF ECONOMIC EXPOSURE • A. APEN SKIING COMPANY • 1. Firm’s 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.

10. IDENTIFYING ECONOMIC EXPOSURE • B. PETROLEOS MEXICANOS (PEMEX) • 1. The firm’s exchange rate risk • affected cost but not revenues. • 2. Economic impact • a. Revenues: none ($ pricing) • b. Costs: decreased • c. Net effect: increased US$ flows

11. 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

12. 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

13. PART V.AN OPERATING MEASURE OF EXCHANGE RISK • A workable approach can be • Regression Analysis • Variables: • changes in parent’s cashflows • Average nominal exchangerate change

14. 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).

15. PART VI.MANAGING OPERATING EXPOSURE • Operating exposure management requires long-term operating adjustments. • Adjustments/decisions are related to marketing, production and finance.

16. MANAGING OPERATING EXPOSURE • II. Marketing Management Adjustments • A. Market Selection • use pricing advantage to carve out market share (domestic or foreign)

17. 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.

18. MANAGING OPERATING EXPOSURE • C. Product Strategy • exchange rate changes may alter • 1. The timing of new product introductions/deletions • 2. Product innovation • (for decreasing elasticity)

19. MANAGING OPERATING EXPOSURE • III. Product Management Adjustments • A. Input mix • B. Shift production among plants • C. Plant location • D. Raising productivity

20. MANAGING OPERATING EXPOSURE • IV. Planning For Exchange-Rate Changes • With better planning and morecompetitive options, firms can change strategies substantiallybefore the impact of an currency change makes itself felt. • Implication: compaction of adjustment period following an exchange-rate change.

21. MANAGING OPERATING EXPOSURE • Financial Management of ExchangeRate Risk: Financial manager’s Role in Marketing and Production • Provide local manager with forecasts of inflation and exchangerate changes • Identify and focus on competitive exposure

22. MANAGING OPERATING EXPOSURE • Design the evaluation criteria so that operating managers neitherrewarded or penalized forunexpected exchange-ratechanges. • Estimate and hedge the operatingexposure after adjustments made. • Currency matching (asset-liability, casf flow)