Measuring and Managing Economic Exposure Chapter 10

CHAPTER 10 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

Steps to the Creation of an Economic Exposure Strategy Step 1. Identify the exposure Step 2. Define the risks Step 3. Develop guidelines to create a strategy Step 4. List the operating exposures Step 5. Measure (calculate) the economic exposure Step 6. Develop methods to manage risk

PART I FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE Step I. Identify the exposure A. Economic exposure defined: focuses on the future impact of unexpected currency fluctuations on firm’s value. B. 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 Step 2. Define the risks C. Definition: Economic exposure =Transaction exposure + Operating exposure D. Operating Exposure: arises because currency fluctuations alter a company’s future revenues and expenses.

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE E. Real Exchange Rates Changes and Risk Nominal v. real exchange rates: real rate has been adjusted for price changes. Assume: no two nations have the same annual rate of inflation.

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE F. 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.

PART II THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES I. Operating Exposure begins: the moment a firm starts to invest in a market subject to foreign competition or in sourcing goods or inputs abroad

THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES Step 3. Develop guidelines to create a strategy II. ECONOMIC CONSEQUENCES A. 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

THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES B. During an appreciation of importer’s home currency: Exporters face two choices: 1. keep prices constant (but lose sales) or 2. adjust prices to foreign currency to maintain market share (lose profits)

Pricing Flexibility is key If HC Appreciates Pricing Flexibility is key

If HC Appreciates C. 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 The Ford Corp in Indonesia, 1997

If HC Appreciates D. Product Differentiation Price elasticity depends on degree of differentiation The greater the differentiation, the more the firm can control its prices. e.g. Daimler Chrysler Corp.

If HC Appreciates E. The Ability to Shift Production and to source inputs from other countries e.g. Japanese car makers (Toyota) in the late 1980’s who lost market share due to their inabililty to shift production

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE F. SUMMARY 1. the economic impact of a currency change depends on the offset by the difference in inflation rates or the change in real exchange rates. 2. It is the relative price changes that ultimately determine a firm’s long-run exposure.

PART III IDENTIFYING ECONOMIC EXPOSURE Step 4. List the new risks I. Operating exposure begins with New product development A distribution network Brand name development Marketing to foreign markets Foreign supply contracts Overseas production facilities

IDENTIFYING ECONOMIC EXPOSURE II. Key Questions to Identify Risk A. Where is the company selling? B. Who are the Company’s key competitors? C. How sensitive is demand to price? D. Where is the company producing? E. Where are the company’s inputs coming from? F. How are the company’s inputs and outputs priced?

PART IV CALCULATING ECONOMIC EXPOSURE Step 5. Measure the economic exposure To measure operating exposure requires a longer-term perspective. i.e. Cost and price competitiveness could be affected by unexpected exchange rate changes

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

PART V. AN OPERATIONAL MEASURE OF EXCHANGE RISK I. Operational Definition of Economic Risk A. 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 Measure using Regression Analysis (e.g. Choi and Jiang 2009)

PART VI MANAGING OPERATING EXPOSURE I. INTRODUCTION Step 6. Develop strategies to manage economic exposure Operating exposure management requires long-term operating adjustments and the involvement of ALL departments.

MANAGING OPERATING EXPOSURE 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 (new) D. Raising productivity

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