International Financial Management Vicentiu Covrig 1 Management of Economic Exposure (chapter 12)

International Financial Management Vicentiu Covrig 2 Types of foreign exchange exposure/risk Translation exposure: - Arises because reporting and consolidating financial statements requires conversion from foreign to local currency Transaction exposure - Arises because of changes in the domestic currency value of the firm’s outstanding obligations in foreign currency. Economic/Operating Exposure - Arises because of changes in the firm’s competitive position

International Financial Management Vicentiu Covrig 3 Economic/Operating Exposure: Definition The effect of random changes in exchange rates on the firm’s competitive position, future sales, costs, cash flows Two misconceptions about the source of economic exposure: 1. “ Only firms that have foreign operations are exposed to the exchange rate changes” 2. “ If all sales and/or purchases are denominated in domestic currency, then a firm is not exposed to the exchange rate changes” Not easily measurable. However, there exist statistical measurements of operating exposure

International Financial Management Vicentiu Covrig 4 If a U.S. MNC were to run a regression on the dollar value (P) of its British assets on the dollar pound exchange rate, S($/£), the regression would be of the form: Where a is the regression constant and e is the random error term with mean zero. The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S. How to measure Economic Exposure

International Financial Management Vicentiu Covrig 5 An Illustration of Economic Exposure In the last three years the dollar depreciated sharply against the Euro, Yen and other major currencies Volkswagen GMBH. (VW) produces most of its cars in Germany but its biggest export market is the United States Note that the currency exposure for VW has two components: - The Conversion Effect: - The Competitive Effect:

International Financial Management Vicentiu Covrig 6 Determinants of Operating Exposure Recall that operating exposure cannot be readily determined from the firm’s accounting statements as can transaction exposure The firm’s operating exposure is determined by: - The market structure of inputs and products: how competitive or how monopolistic the markets facing the firm are - The firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes Facing XR changes, a firm may choose one of these: - pass the cost shock fully to its selling prices (complete XR pass-through) - full absorb the shock and keep the prices unchanged (no pass-through) - combination of the two

International Financial Management Vicentiu Covrig 7 Managing Operating Exposure Selecting Low Cost Production Sites Flexible Sourcing Policy A firm may wish to diversify the location of their production sites to mitigate the effect of exchange rate movements. Diversification of the Market Financial Hedging Financial Hedging is distinct from operational hedging Financial Hedging involves use of derivative securities such as currency swaps, futures, forwards, currency options

International Financial Management Vicentiu Covrig 8 Learning outcomes Discuss the three types of exchange rate exposure Define economic/operating exposure to exchange risk Explain how you can measure the economic/operating exposure Discuss the determinants of operating/economic exposure Discuss how a company can manage its operating exposure Briefly discuss Merck’s five-step procedure for financial hedging (see the illustrated mini case on page 296)