Measuring and Managing Economic Exposure CHAPTER 11 Measuring and Managing Economic Exposure

Foreign Exchange Risk and Economic Exposure Economic exposure focuses on the impact of currency fluctuations on firm’s value. The market value of a firm = PV of the firm’s future cash flows Economic exposure = Transaction exposure + Operating exposure: Operating exposure Sensitivity of a company’s future revenues and expenses to currency fluctuations. A longer-term perspective is required to measure operating exposure. i.e. Exchange rate changes affect cost and price competitiveness.

Ex1. Operating Exposure American film makers vs. European distributors when the Euro slumps. Who will take the costs caused by euro depreciation? If the contract is made in Euro, American film makers take all the costs, decreasing future revenues of American producers. If the contract is made in dollar, the European distributors will take all the costs but they will curtail their purchase of American films, decreasing the revenues of American film producers. American film makers suffer from the decline of their revenues because of lower price competitiveness.

Ex1. Operating Exposure Cost competitiveness of American film makers falls down as well when euro depreciates. A film-maker pre-sells the foreign rights to distributors before film-making. The pre-sale of film rights to European distribution accounts for 1/3 of a film’s budget. Decreases in pre-sale of rights caused by euro depreciation increases the costs of making films because of cost increases in regards to raising additional capital, decreasing the cost competitiveness of American films.

Ex2. Operating Exposure U.S. computer company has a wholly owned British subsidiary, Albion Computers PLC, which manufactures and sells PC in the U.K. market. Albion Computers imports microprocessors from Intel, which sells them for $512 per unit. Each Intel’s microprocessor currently costs ￡320 at the current exchange rate of $1.60 per pound. The unit variable cost is ￡650, which comprises ￡320 for the imported input and ￡330 which are the other variable costs. What happens to the dollar operating cash flows of Albion Computer if the pound depreciates?

Ex2. Operating Exposure Operating cash flows of Albion Computers Case 1: The pound price of the imported input increases and the pound price of the computer is same. Lower cost competitiveness decreases its future revenues. Case 2: The selling price of the computer increases. The increase in the selling price caused by costs of the imported input will reduce price competitiveness of Albion computers. Loss of price competitiveness will reduce Albion computer’s revenue.

Ex2. Operating Exposure When the pound depreciate from $ 1.60 to $ 1.40, the dollar operating cash flow will change by both the competitive effect and the conversion effect. The Competitive Effect Pound depreciation -> increases in input costs. -> lowering cost and price competitiveness -> reduce Albion Computers’ competitiveness -> Reduce future net cash flows The Conversion Effect A given operating cash flows in pounds will be converted into a lower dollar amount after the pound depreciation.

Foreign Exchange Risk and Economic Exposure Real Exchange Rates Changes and Exchange Risk Law of one price suggests the real exchange rate matters. If PPP does not hold, the real exchange rate may change. The change in real exchange rate =

Foreign Exchange Risk and Economic Exposure The pound depreciates by 5% during the year. If the inflation rates were 5% in U.K. and 10% in U.S., what is the real exchange rate change? Answer: The change in the real exchange rate is about 9 % depreciation of the pound. (-9.318%) U.S. exporter faces poor price and cost competitiveness. If nominal exchange rates change with an equal price change, there is no alteration to cash flows. If the real exchange rate changes, it causes relative price changes and changes in purchasing power. Let S(0) = the price of the pound in terms of dollars which is the base exchange rate. (S(1)-S(0))/S(0) = -.05 -> S(1)=0.95 S(0). -> The real exchange rate of S(1) = 0.95S(0)* (1.05)/1.01 = 0.9068 S(0) Thus, the change in real exchange rate = (0.9068 – 1) S(0)/S(0) = -0.09318

Foreign Exchange Risk and Economic Exposure A decline in the real value of home currency makes exports and import-competing goods more competitive. An increase in the real value of home currency makes imports more competitive. 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)

SUMMARY The economic impact of a currency change depends on the change in real exchange rates. It is the relative price changes that ultimately determine a firm’s long-run exposure. You need to discern the real exchange rate change from the nominal exchange rate.

Economic Consequences  

Price Flexibility e.g. Mercedes Benz cars, Apple mobile phone If price elasticity of demand is low, the high price flexibility a firm has. High price elasticity products: High availability of good substitutes, Labor intensive products, More standardized products Low price elasticity products: Capital intensive products Textile industry (high price elasticity) vs. Apparel industry (low price elasticity) Economy of developing countries usually are more vulnerable to foreign exchange rate risk. Degree of product differentiation The greater the differentiation, the more the firm can control its prices. e.g. Mercedes Benz cars, Apple mobile phone

How to Measure Economic Exposure Economic exposure is the sensitivity of the future home currency value of the firm’s assets and liabilities and the firm’s operating cash flow to random changes in exchange rates. There exist statistical measurements of sensitivity. Sensitivity of the firm’s operating cash flows to random changes in exchange rates. (operating exposure) Sensitivity of the firm’s net asset value in the home currency to random changes in exchange rates. (asset exposure) Cash flows from future liquidation

Channels of Economic Exposure Asset Exposure Home currency value of assets and liabilities Exchange rate fluctuations Firm Value Operating Exposure Future operating cash flows

How to Measure Economic Exposure If a U.S. MNC were to run a regression the dollar value (P) of its British assets on the exchange rate, S($/£), the regression would be of the form: P = a + b×S + e Where a is the regression constant. e is the random error term with mean zero. The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S.

How to Measure Economic Exposure The exposure coefficient, b, is defined as follows: Cov(P,S) Var(S) b = Where Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate, and Var(S) is the variance of the exchange rate.

How to Measure Economic Exposure The exposure coefficient shows that there are two sources of economic exposure: the variance of the exchange rate and the covariance between the dollar value of the asset and exchange rate Cov(P,S) Var(S) b =

Example Suppose a U.S. firm has an asset in Britain whose local currency price is random. For simplicity, suppose there are only three states of the world and each state is equally likely to occur. The future local currency price of this British asset (P*) as well as the future exchange rate (S) will be determined, depending on the realized state of the world.

Example (continued) State Probability P* S S×P* Case 1 1 1/3 £980 $1.40/£ $1,372 2 £1,000 $1.50/£ $1,500 3 £1,070 $1.60/£ $1,712 Case 2 $1,400 £933 £875 Case 3 $1,600

Example (continued) In case one, the local currency price of the asset and the exchange rate are positively correlated. This gives rise to substantial exchange rate risk. State Probability P* S S×P* Case 1 1 1/3 £980 $1.40/£ $1,372 2 £1,000 $1.50/£ $1,500 3 £1,070 $1.60/£ $1,712

Example (continued) In case two, the local currency price of the asset and the exchange rate are negatively correlated. This ameliorates the exchange rate risk substantially. (Completely in this example.) State Probability P* S S×P* Case 2 1 1/3 £1,000 $1.40/£ $1,400 2 £933 $1.50/£ 3 £875 $1.60/£

Example (continued) In case three, the local currency price of the asset is fixed at £1,000 This “contractual” exposure can be completely hedged only over short run. Only conversion effect exists. State Probability P* S S×P* Case 3 1 1/3 £1,000 $1.40/£ $1,400 2 $1.50/£ $1,500 3 $1.60/£ $1,600

INTRODUCTION How to hedge operation exposure? Operating exposure management requires long-term operating adjustments and the involvement of all departments.

Managing Operating Exposure 1. Selecting Low Cost Production Sites 2. Flexible Sourcing Policy 3. Marketing Strategy 4. R&D and Product Differentiation 5. Financial Hedging

Selecting Low Cost Production Sites A firm may wish to diversify the location of their production sites to mitigate the effect of exchange rate movements. This is one of reasons why the company wants FDI. e.g. Honda built North American factories in response to a strong yen.

Flexible Sourcing Policy Sourcing does not apply only to components, but also to “guest workers”. e.g. Japan Air Lines hired foreign crews to remain competitive in international routes in the face of a strong yen, but later contemplated a reverse strategy in the face of a weak yen.

Marketing Strategy Diversification of the market To take advantage of economies of scale and diversification of exchange rate risk. Change price competitive products to more quality conscious, less price-sensitive products. Volkswagen: low priced and low maintenance car before 1970. The appreciation of DM in the early of 1970 changed VW’s product strategy. High priced cars with high quality and attractive styling. Achieve high price flexibility by gaining loyal customers.

R&D and Product Differentiation Successful R&D that allows for cost cutting enhanced productivity product differentiation. Successful product differentiation gives the firm less elastic demand—which may translate into less exchange rate risk.

Financial Hedging The goal is to stabilize the firm’s cash flows in the near term. Financial Hedging is distinct from operational hedging. Financial Hedging involves use of derivative securities such as currency swaps, futures, forwards, currency options, among others. It is not appropriate to use financial hedging to reduce operating exposure since operating exposure is related to risk of long-term operating cash flows.