Presenter: Van Phan ECONOMIC EXPOSURE

Presenter: Van Phan Agenda I. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE II. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES III. IDENTIFYING ECONOMIC EXPOSURE

Presenter: Van Phan CONCEPT OF FOREIGN EXCHANGE EXPOSURE Economic exposure focuses on the impact of currency fluctuations on the firm’s value. 1.Expectations about fluctuations must be incorporated in all basic decisions of the firm. 2.Definitions: a. Accounting exposure: impact on firm’s balance sheet b. Economic exposure i.Cash Flow exposure ii.Net worth exposure

Presenter: Van Phan Definition Economic Exposure: The risk that exchange rate changes may affect the present value of future income streams.

Presenter: Van Phan Case 1: No Deviation From PPP An example of a U.S corporation’s British Subsidiary Assumption: PPP holds –Nominal ER=  -  * =  S –Domestic inflation less foreign inflation should equal the change in the spot rate. –Implies that the higher inflation country should see its currency depreciate.=  depreciation of £ is the result of higher inflation in UK than in U.S

Presenter: Van Phan No Deviation From PPP £ price of the product will rise in accordance with British inflation Results –$price –$ AC –$ margin No change –Volume –Profit

Presenter: Van Phan Case 2: Real ER changes and self- contained subsidiary-Price-Taker Perfectly competitive market British operation services the local market and undertakes all production locally £ depreciates in real term – £ Price: not change: price taker –$ Price: change –$ Costs: change –$ Profit margin: Decline in proportion of ER change

Presenter: Van Phan Real ER changes and self- contained subsidiary-Price- Taker MR $ P1P1 Q0Q0 AC Quantity MR’ Po MC Co C1C1

Presenter: Van Phan Real ER changes and self- contained subsidiary-Price-Maker The result is the same: Why –£ denominated demand curve: no change with the depreciation of £ –$ equivalent demand curse shift down £ Price: not change: no change in D $ Price: change $ Costs: change $ Profit margin: Decline in proportion of ER change

Presenter: Van Phan Case 3: Real ER and a World Output Market Assumption: –British subsidiary functions in a world market for output –The world price is determined in $ (MR=MR’) Results of £ depreciation –Change the cost structure because of the local inputs –Increase the production =  Increase profit

Presenter: Van Phan Real ER and a World Output Market MR=MR’ $ Q0Q0 AC’ Quantity Q1Q1 Po Co C1C1 AC MC’ MC

Presenter: Van Phan Case 4: Real ER and a World Input Market Assumption: –Output is priced in £ –Input is priced in $ (MR=MR’) Results of £ depreciation –Shift the $MR down –Cost function does not shift down =  cut production to reduce costs=  profit declines

Presenter: Van Phan Case 5: Real ER and a World Input & Output Market Assumption –Competing in a world of output –Producing the output with factors supplied in a world input market Results of £ depreciation –No shift the $MR –No shift the cost function=  no economic exposure

Presenter: Van Phan Conclusion Local Currency Depreciation Cases U.S Dollar Price U.S. Dollar AC U.S Dollar Margin Volume U.S Dollar Profit PPP holds No Change Real Depreciation and self- contained DecreaseDecreaseDecrease No Change Decrease Real Depreciation, world output Price Taker: No change Price Maker: DecreaseIncreaseIncreaseIncrease Real Depreciation, world input Decrease No change DecreaseDecreaseDecrease Real Depreciation, world output & input No change