Multinational Financial Management Alan Shapiro 7th Edition J Multinational Financial Management Alan Shapiro 7th Edition J.Wiley & Sons Power Points by Joseph F. Greco, Ph.D. California State University, Fullerton

MEASURING AND MANAGING ECONOMIC EXPOSURE CHAPTER 11 MEASURING AND MANAGING ECONOMIC EXPOSURE

CHAPTER OVERVIEW I. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE II. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES III. IDENTIFYING ECONOMIC EXPOSURE IV. CALCULATING ECONOMIC EXPOSURE V. AN OPERATIONAL MEASURE OF EXCHANGE RISK VI. MANAGING OPERATING EXPOSURE

PART I. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE A. Economic exposure focuses on the impact of currency fluctuations on firm’s value. 1 . Expectations about the fluctuation must be incorporated in all basic decisions of the firm.

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE 2. Definitions: a. Accounting exposure impact on firm’s balance sheet b. Economic exposure 1.) Transaction 2.) Operating

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE THE REAL EXCHANGE RATE

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE B. Real Exchange Rates and Risk 1. Nominal v. real exchange rates: the real rate has been adjusted for price changes.

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 real exchange rate. b. It is the relative price changes that ultimately determine a firm’s long-run exposure.

PART II. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES II. ECONOMIC CONSEQUENCES A. Transaction exposure 1. On-balance sheet 2. Off-balance sheet

THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES II. ECONOMIC CONSEQUENCES (con’t) B. Operating Exposure : real rate change 1. Pricing flexibility is key 2. Product differentiation 3. Substitution of inputs

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; and fluctuations in the real exchange rate delineate the firm’s true economic exposure.

PART III. IDENTIFYING ECONOMIC EXPOSURE III. CASE STUDIES OF ECONOMIC EXPOSURE A. ASPEN SKIING COMPANY 1. Firm’s exchange rate risk affected its sales revenues.

IDENTIFYING ECONOMIC EXPOSURE A. ASPEN SKIING COMPANY (con’t) 2. Although there was no translation risk, the global market with its exchange rate risk and its competitors impacted market demand.

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 b. Costs: decreased c. Net effect: increased US$ flows

IDENTIFYING ECONOMIC EXPOSURE C. TOYOTA MOTOR COMPANY 1. Exchange rate risk affected BOTH revenues and costs. 2. Flow back effect: previously exported goods return with increased domestic competition. 3. Lower profit margins domestically

PART IV. CALCULATING ECONOMIC EXPOSURE IV. A quantitative assessment of economic exposure depends on underlying assumptions concerning: A. future cash flows; B. sensitivity to exchange rate changes.

PART V. AN OPERATIONAL MEASURE OF EXCHANGE RISK V. NEED FOR A WORKABLE APPROACH A. Regression Analysis 1. Variables a. Independent: changes in parent’s cash flows b. Dependent: Average nominal exchange rate change.

AN OPERATIONAL MEASURE OF EXCHANGE RISK B. REGRESSION EQUATION -approach based on the operational definition of the exchange risk faced by a parent or one of its affiliates: -a company faces exchange risk to the extent that variations in the dollar value of the unit’s cash flows are correlated with variations in the nominal exchange rate

AN OPERATIONAL MEASURE OF EXCHANGE RISK where CFt = CFt - CFt-1 and CFt is the dollar value of total affiliate(parent)cash flows in period t EXCHt = EXCHt - EXCHt-1 equals the average nominal exchange rate during period t u = a random error term

AN OPERATIONAL MEASURE OF EXCHANGE RISK 1. Output measures: a. Beta coefficient (b) measures the association of changes in cash flows to exchange rate changes.

AN OPERATIONAL MEASURE OF EXCHANGE RISK b. the higher the percentage change of cash flow to changes in exchange rates, the greater the economic exposure (higher beta values).

AN OPERATIONAL MEASURE OF EXCHANGE RISK VI. SUMMARY: A. The focus of the accounting profession on the balance sheet impact of currency changes has led to ignoring the important impact on future cash flows.

AN OPERATIONAL MEASURE OF EXCHANGE RISK B. For firms incurring costs and selling products in foreign countries, the net effect of currency changes may be less important in the long run.

AN OPERATIONAL MEASURE OF EXCHANGE RISK C. To measure exposure properly, you must focus on inflation-adjusted or real exchange rates instead of nominal or actual exchange rates.

AN OPERATIONAL MEASURE OF EXCHANGE RISK D. It is difficult in practice to determine what the actual economic impact of a currency change will be.

PART VI. MANAGING OPERATING EXPOSURE I. INTRODUCTION Operating exposure management requires long-term operating adjustments. A. Real v. Nominal Changes 1. Relative price changes leads to marketing and/or production revisions

MANAGING OPERATING EXPOSURE B. Proactive Marketing and Production Initiatives 1. Marketing: market selection product strategy pricing strategy promotional strategy

MANAGING OPERATING EXPOSURE B. Proactive Marketing and Production Initiatives (con’t) 2. Production: product sourcing input mix plant location raising productivity

MANAGING OPERATING EXPOSURE II. Marketing Management Adjustments A. Market Selection 1. use advantage to carve out market share 2. Market segmentation

MANAGING OPERATING EXPOSURE B. Pricing strategy: Expectations critical 1. If HC value falls, exporter gains competitive advantage by increasing unit profitability and market share. 2. The higher price elasticity of demand, the more currency risk the firm faces by product substitution.

MANAGING OPERATING EXPOSURE 3. Following HC depreciation, local firm may have much more freedom in its pricing. C. Promotional Strategy

MANAGING OPERATING EXPOSURE D. Product Strategy exchange rate changes may alter 1. The timing of new product introductions, 2. Product deletion , 3. Product innovation.

MANAGING OPERATING EXPOSURE III. Product Management Adjustments product sourcing and plant location are the principal variables to manipulate. A. Input mix B. Shift production among plants C. Plant location D. Raising productivity

MANAGING OPERATING EXPOSURE IV. Planning For Exchange-Rate Changes A. With better planning and more competitive options, firms can change strategies substantially B. before the impact of an currency change makes itself felt. C. Implication: compaction of adjustment period following an exchange-rate change.

MANAGING OPERATING EXPOSURE V. Financial Management of Exchange Rate Risk: Financial manager’s Role in Marketing and Production A. Provide local manager with fore- casts of inflation and exchange- rate changes. B. Identify and focus on competitive exposure.

MANAGING OPERATING EXPOSURE C. Design the evaluation criteria so that operating managers neither rewarded or penalized for unexpected exchange-rate changes. D. Estimate and hedge the operating exposure after adjustments made.