CHAPTER 11 Measuring and Managing Economic Exposure

PART I. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE I.FOREIGN EXCHANGE RISK A.Economic exposure focuses on the impact of currency fluctuations on firm’s value. 1.The most important aspect of foreign exchange risk management: Incorporate expectations about the risk into all basic decisions of the firm.

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE 2.Definition: Economic exposure = Transaction exposure + Operating exposure: arises because currency fluctuations alter a company’s future revenues and expenses.

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE To measure operating exposure requires a longer-term perspective. i.e. Cost and price competitiveness could be affected by exchange rate changes

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE Operating Exposure begins: the moment a firm starts to invest in a market subject to foreign competition or in sourcing goods or inputs abroad

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE The new investment includes: New product development A distribution network Brand name development Marketing Foreign supply contracts Production facilities

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

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE C. Implications 1. If nominal rates change with an equal price change, no alteration to cash flows. 2. If real rates change, it causes relative price changes and changes in purchasing power.

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE decline A decline in the real value of a currency: makes exports and import-competing goods more competitive appreciating An appreciating currency makes: imports and export-competing goods more competitive

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE 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)

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 change in real exchange rates. 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 I.ECONOMIC CONSEQUENCES The impact on Operating Exposure of a real rate change depends upon: Pricing flexibility and 1.Price elasticity of demand 2.Degree of product differentiation 3.The Ability to shift production and the substitution of inputs

If HC Appreciates Pricing Flexibility is key

If HC Appreciates Can the firm maintain its profit margins both at home and abroad? If price elasticity of demand is low, the more price flexibility a firm has. i.e. Availability of good substitutes

If HC Appreciates Product Differentiation price elasticity depends on degree of differentiation The greater the differentiation, the more the firm can control its prices. e.g. Mercedes Benz cars

If HC Appreciates The Ability to Shift Production and to source inputs from other countries e.g. Japanese car makers in the late 1980’s

PART II.MANAGING OPERATING EXPOSURE I.INTRODUCTION Operating exposure management requires long-term operating adjustments and the involvement of all departments.

MANAGING OPERATING EXPOSURE Marketing Strategy II.Marketing Strategy A. Market Selection: use competitive advantage to carve out market share when currency values change

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

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

MANAGING OPERATING EXPOSURE III.Product Management Adjustments A.Input mix “shop the world” B.Shift production among plants C.Plant relocation D.Raising productivity

MANAGING OPERATING EXPOSURE IV.Planning For Exchange-Rate Changes A.Develop contingency plans with plausible scenarios before the impact of acurrency change makes itself felt. e.g. flexible mfg systems

MANAGING OPERATING EXPOSURE V. Financial Management of Exchange Rate Risk: Financial manager’s Role Structure the firm’s liabilities in such a way that the reduction in asset earnings is matched by corresponding decrease in cost of servicing liabilities.

MANAGING OPERATING EXPOSURE A.Provide local manager with forecasts 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.