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 The role of demand elasticity  Exactly how much of a price reduction will be required (in terms of the foreign currency price) will depend upon the price elasticity of demand for the good.  If demand is very elastic, a small decrease will be sufficient to cause demand to go up a lot. This will mean that the exporter’s profits will be higher.  The flip side of this is that if there is an appreciation of the home currency, the hit on profits will be large, as well.  Consequently, the more elastic the demand for the good, the greater the exposure of the exporter to exchange rate changes of a given volatility.  Marketing/Advertising may be useful in creating brand loyalty and reducing the price elasticity of demand for the firm’s products.

P.V. Viswanath7 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. Viswanath8 Pricing Flexibility  The key issue for a domestic firm, when the dollar appreciates is its pricing flexibility.  Can it maintain its dollar margins both at home and abroad?  Can it maintain its dollar price on domestic sales in the face of lower-priced foreign imports?  In the case of foreign sales, can the firm raise its foreign currency selling price to preserve its dollar profit margin?

P.V. Viswanath9 Price Elasticity of Demand  The less price elastic the demand for the company’s products, the more price flexibility the company has.  Price elasticity depends on the degree of competition and the location of key competitors.  The more differentiated a company’s products are, the less competition it will face. (e.g. Mercedes Benz cars)  If most competitors are based in the home country, then all will face the same change in their cost structure, and no one producer will be at a disadvantage vis-à-vis any other domestic producer.  Commodity exporters are very vulnerable to real exchange effects because of the non-differentiated nature of their products.

P.V. Viswanath10 More about Flexibility  The firm’s susceptibility to exchange rate risk depends also on its ability to shift production and the sourcing of inputs among countries.  A foreign subsidiary selling goods in its local market cannot increase local prices enough to make up for a local currency devaluation. However, the devaluation will also help in fending off import competition. the dollar value of local production costs will drop; however, the higher the import content of local inputs, the less dollar production costs will decline.  if the firm can substitute local inputs for imported inputs, it can cope better with the devaluation.  if the firm can sell in other markets, it can keep dollar revenues high.

P.V. Viswanath11 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. Viswanath12 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. Viswanath13 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. Viswanath14 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.