CHAPTER 11

1. CHAPTER 11 Defining Foreign Exchange Risk

2. PART I. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE • I. FOREIGN EXCHANGE RISK • A. Economic exposure • focuses on the impact of currency • fluctuations on firm’s value. • 1 . The most important aspect of foreign exchange risk management: • Incorporate expectations about the risk into all basic decisions of the firm.

3. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE • 2. Definition: • Economic exposure = • Transaction exposure + • Operating exposure: • arises because currency fluctuations alter a company’s future revenues and expenses.

4. 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

5. 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

6. 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

7. 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.

8. 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.

9. 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

10. 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)

11. 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 firm’s long-run exposure.

12. 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

13. If HC Appreciates Pricing Flexibility is key

14. 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

15. 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

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

17. PART II.MANAGING OPERATING EXPOSURE • I. INTRODUCTION • Operating exposure management requires long-term operating adjustments and the involvement of all departments.

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

19. 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.

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

21. MANAGING OPERATING EXPOSURE • III. Product Management Adjustments • A. Input mix “shop the world” • B. Shift production among plants • C. Plant relocation • D. Raising productivity

22. 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

23. MANAGING OPERATING EXPOSURE • V. Financial Management of Exchange Rate Risk: • Financial manager’s Role • Structure the firm’s liabilities in such a way that the reduction in asset earnings is matched by corresponding decrease in cost of servicing liabilities.

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

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