Economic Exposure and Country Risk Management Day 5 Dr Michael Dowling

Economic Exposure Risk Management

Economic Exposure  Operating exposure in an international context  Measuring and calculating operating exposure  Managing operating exposure

Operating exposure Operating exposure is determined by the structure of the markets in which the firm operates and the firm’s ability to mitigate the effect of exchange rate changes by adjusting its business strategy

Distinguishing from last week  Last week we looked at hedging individual exchange rate risks, whereas now we are looking at more long-term issues  E.g. Toyota produces 70% of their US cars in the US? This is a more strategic decision than an immediate financial hedging decision

Simkins and Laux (1996) IndustryMarket BetaForex Beta Beverage Building materials Furniture Aerospace Positive (negative) forex beta means that stock returns tend to move down (up) as the dollar appreciates

Measuring economic exposure  Currency risk or uncertainty is not the same as currency exposure, which measures “what is at risk”  A firm might not face exposure even if exchange rates change randomly (e.g. as foreign assets might change in value to reflect the exchange rate fluctuation)  Highest exposure is when foreign assets do not change to reflect exchange rate changes

A simple formula …

… and a simple chart …

Example: an Irish company has a US asset… OutcomeProbabilityP*SSP 1 1/3$980€0.80€ /3$1,000€0.90€ /3$1,070€1.00€1,070 Mean €0.90€918

Computation of beta SP = 1/3 (€784 + €900 + €1,070) = €918 S = 1/3 (€ € €1.00) = €0.90 Var (S)= 1/3 [( ) 2 +( ) 2 + ( ) 2 ] = 0.02/3 = Cov (SP) = 1/3 [( )( )+( )( )+( )( ) = 28.6/3 = β = / = $1,423 (thus, $1,423 is what we should be aiming to hedge)

Will we then be fully hedged?

The optimum hedge amount will be ‘b’ i.e. $1,423

An example to try State 1State 2State 3State 4 Probability 25% S €2.40/Z€2.20/Z€2.00/Z€1.80/Z P*P* Z4,000Z3,600Z3,200Z2,800 SP €9,600€7,920€6,400€5,040

Solution

Managing operating exposure  Need to consider exchange rate exposure in the firm’s long-term strategic planning. Some strategies include: 1. Selecting low-cost production sites: If the firm’s domestic currency is strong or expected to appreciate. 2. Flexible sourcing policy: Sourcing from where input costs are low (incl. labour: Irish Ferries)

Contd… 3. Diversification of market: Do we have the flexibility to reduce sales in a market if the currency is devalued 4. R&D and product differentiation: Create price elasticity and lower exchange exposure (Porsche) 5. Financial hedging: As covered last week, ideally as a short-term measure (but, Xerox…$2m per quarter on $5.5bn)

Country Risk Management

Content:  How do firms internationalise?  Why do firms invest overseas?  Political risk and FDI

Foreign Direct Investment

FDI…  Firms become multinational when they undertake foreign direct investments (FDI)  OECD: “FDI reflects the objective of obtaining a lasting interest by a resident entity in one economy in an entity resident in an economy other than that of the investor”  It represents a significant organisational expansion by the firm

Why do firms invest overseas?

Let’s look at some internationalisation strategies 1. Exporting Fairly safe way to address foreign demand as capital requirements / start-up costs are minimal. Low risk and quick profits. Allows learning about the foreign market.

2. Sales Subsidiary Once an initial foundation has been established, a sales subsidiary can be set up abroad, rather than using export agents. This allows you to deal directly with customers. Also service and distribution centres. 3. Overseas Production Exporting has a cost. Means you cannot realise as large a profit as you might, had you produced local to the foreign market. Allows adapting to the market, and shows greater commitment.

Key factors in decision to internationalise… 1. Trade barriers 2. Imperfect labour market 3. Intangible assets 4. Product life cycle 5. Vertical integration 6. Shareholder diversification services

1. Trade barriers Governments can impose tariffs, quotas, and other restrictions on the export and import of goods and services. Also natural trade barriers like distance. Moving production can surmount these restrictions. When is a catfish a basa fish?

2. Imperfect labour markets Norway $53.89 per labour hour Germany Ireland Poland 7.50 Mexico 5.38 Philippines 1.50 Labour in a country can be severely underpriced relative to its productivity because workers are not allowed to freely move across national boundaries to seek higher wages. When workers are not mobile because of immigration barriers, firms themselves should move to the workers in order to benefit from underpriced labour

3. Intangible assets Internalisation theory: firms with assets with a public good property tend to invest directly in order to use assets on a larger scale and avoid misappropriations of intangible assets

4. Product life cycle  When firms first introduce new products they tend to keep production at home, close to customers, and learning from feedback  Exports rise as the product becomes known about internationally  As product matures, tend to internationalise to lower production costs  This is quite an old theory though (Vernon, 1966) and there is evidence that firms are internationalising much earlier now

5. Vertical integration 6. Shareholder diversification  Vertical integration : firms might internationalise to secure supply of inputs, and control all stages of production (Fordlandia)  Shareholder diversification services : firms might internationalise to expose shareholders to the benefits of international diversification Both of these reasons are now considered dated (although see Mittal)

International M&A  Do firms benefit from international acquisitions?  It depends…  If they have some intangible assets that can be leveraged, then yes (e.g. Japanese overseas acquisitions)  But firms can encounter political difficulties that reduce returns. Also familiarity bias can reduce returns (UK acquisition of US firms)

Political Risk  A sovereign country can take various actions that may adversely affect the interests of MNCs  Political risk usually varies based on the type of firm, but:  Macro risk : where all foreign operations are affected by adverse political developments in the host country  Micro risk : where only selected areas of foreign business operations or particular foreign firms are affected

Three types… Transfer Risk, which arises from uncertainty about cross-border flows of capital, payments, know-how Operational Risk, which is associated with uncertainty about the host country’s policies affecting the local operations of MNCs Control Risk, which arises from uncertainty about the host country’s policy regarding ownership and control of local operations

What factors should be considered?  Very flexible and quite subjective, but…  The host government’s political and government system  Track records of political parties and their relative strength  Integration into the world system  The host country’s ethnic and religious stability  Regional security  Key economic indicators

Strategies  Joint ventures (but, BP-TNK)  International / home country support (Sugar Tax if it follows chewing gum tax?)  Insurance (export credits)