Operating Exposure International Corporate Finance P.V. Viswanath.

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Presentation transcript:

Operating Exposure International Corporate Finance P.V. Viswanath

2 Learning Objectives  The implications of exchange rates for the revenues, costs, and profits of companies invovled in international commerce.  Factors affecting the impact of exchange rates on profits elasticity of demand for a company’s products, the types of inputs used, The use of internationally traded inputs Flexibility of production to meet changes in demand Time span consdiered Degree of competition faced in markets where the goods are sold  Even a company with hedged receivables and payables can be affected by foreign exchange exposure.

P.V. Viswanath3 Competitive markets in the short run  An exporting firm in a competitive market will experience an increase in sales revenues and production costs after a real depreciation of its currency.  If the new price is determined in the export market, the dollar price will rise by the amount of the depreciation.  This will lead to an expansion of production.  Consequently, total revenue will rise by more than total costs and so profits will increase.

P.V. Viswanath4 Long-run effects: tradable inputs  The higher profit for a competitive firm from devaluation will encourage existing (domestic) firms to expand output and new (domestic) firms to enter the industry, lowering the product price.  This may limit the period of extra profit for an particular pre-existing firm.  If some of the inputs are internationally tradable, the depreciation will cause their dollar prices to rise.  Similarly, the depreciation may lead to general inflation and competition for inputs, leading to higher production costs.  This will also limit profit improvements

P.V. Viswanath5 Imperfect competition  An exporting firm in an imperfectly competitive market will experience an increase in total revenue and total cost after devaluation when amounts are measured in the firm’s home currency.  The (home) price will rise by less than the currency depreciation because of the downward sloping demand curve.  However, this will partly be compensated for by increased sales, so that revenues will still rise.  A firm must be sufficiently flexible in terms of its production plans, else it will not be able to take advantage of the potential for higher sales.  Total costs will rise in the short run if the cost curve is upward sloping. Still, revenue will rise by more than total cost, and so profit will increase.

P.V. Viswanath6 Imperfect competition  In the longer run, the higher profits can persist if they are not offset by higher input costs in the form of greater competition and costlier traded inputs.  Revenues, costs, and profits that are measured in terms of foreign exchange will also increase from devaluation, although by a lesser amount.  This is because domestic exporters will be able to produce cheaper in terms of the foreign currency. Hence, they will have a higher profit margin.  However, if there is competition, the foreign currency price might even drop. This parallels the fact that the price rise in the domestic currency will be less than the percentage of depreciation.

P.V. Viswanath7 The Case of Importers  Devaluation raises the prices of imports in terms of the devalued currency and reduces the quantity that is imported and sold.  Total revenue and total cost in terms of dollars will fall, and so will the importer’s profit.  A revaluation lowers input prices and raises an importer’s dollar total revenue, total cost, and profit.  Devaluation lowers the prices of imports when these prices are measured in the foreign currency.  Dollar devaluation lowers an importer’s total revenue, total cost, and profit in terms of the foreign currency. Revaluation will raise them.

P.V. Viswanath8 The effect of hedging on exporters  When an arrangement exists to export a stated quantity at a price fixed in home currency, devaluation can temporarily hurt an exporter’s profit. This is true in both dollar and foreign- currency units.  This is because costs are still susceptible to exchange rate effects. If some of the inputs are internationally traded, costs will rise while revenues will not be helped. Similarly, competition among producers, as well as general inflation could raise input costs.  If prices in an export sales agreement are stated as foreign- currency amounts and these are not sold forward, devaluation will raise dollar revenues, costs, and profits of a US exporter via both transaction and operating exposure.

P.V. Viswanath9 The effect of hedging on importers  An importer buying an agreed-upon quantity at an agreed-upon price in dollars will experience no change in dollar revenues, costs, or profits after devaluation.  An importer buying an agreed-upon quantity at prices invoiced in foreign exchange will temporarily experience unchanged dollar revenues, increased costs, and reduced profits.

P.V. Viswanath10 Measuring Exposure: Practical solutions  Suppose stock price information is not available, but profit/income data is available Incomes can be regressed against exchange rate changes to get a measure of the flow effect. The present value of the effect on income must be computed to get the exposure measure.  Another approach is to create scenarios by talking to senior management to see how profits would be affected by exchange rate changes.