2011 EXAMINATION QUESTION (4)  (a) What would a multinational firm do if it expects the local currency to depreciate in the near term? Underline the correct answers (focus on the italics) in what follows:  Buy/sell foreign currency forward  Go for local currency call option / put option  Reduce / increase local currency cash and marketable securities  Relax / tighten local currency credit terms  Hasten / delay collection of hard currency receivables  Borrow locally / abroad  Delay / speed up payment of accounts payable abroad  Delay / speed up dividend and fee remittances to parent company and subsidiaries  Invoice exports in local / foreign currency 1

2011 EXAM QUESTION & ANSWERS (4) (a) A multinational firm would do the following if it expects the local currency to depreciate in the near term: Buy foreign currency forward Go for local currency put option Reduce local currency cash and marketable securities Tighten local currency credit terms Delay collection of hard currency receivables Borrow locally Speed up payment of account payable abroad Speed up dividend and fee remittances to parent company and subsidiaries Invoice exports in foreign currency 2

2011 EXAMINATION QUESTION (4) (b) An American pension fund buys euro bonds worth EUR 10 m (upon maturity a year later) for USD 13.3 m at the current rate of USF per EUR. In addition, it makes a forward sale of EUR 10 m at the forward rate of USD per EUR. (i) What is the cost of hedging, if the future spot rate turns out to be: * EUR 1= USD 1.40 * EUR 1 = USD * EUR 1 = USD

2011 EXAMINATION Q & A (4) (i)  EUR1 = USD m – m = 210 (loss)  EUR1 = USD m – 13.79m = 0 (no loss/gain)  EUR1 = USD m – 13.0 m = 790 (gain) 4

2011 EXAM Q & A (4) (ii) Show how an exchange gain (loss) on the forward market contract is offset by a corresponding exchange loss (gain) in the value of receivable, with a total cash flow of USD million in all the above three instances, resulting in a net gain of USD 490,000 (USD m – USD 13.3 m). XR VAL RECEIV XR G/L CF EUR 1= $1.40 $14 m ( = -210) $13.79m EUR 1= $ $ m zero $13.79m EUR 1= $ 1.30 $13.0 m ( =+790) $13.79m 5

International Finance Economic Exposure & Foreign Exhange Risk LECTURE 8

Measuring Economic Exposure  The objective of managing accounting exposure, is reducing fluctuations in translated earnings.  While it is possible for a company to show very little translation losses, it still has to worry about underlying volatility in currency markets.  Fluctuations in exchange rates can have ‘real’ effects on cash-flows.  There is a major discrepancy between accounting practice and economic reality  esp. in terms of measuring exposure. 7

Measuring Economic Exposure (cont’d)  In contrast to accounting definition, economic definition focuses on the impact of an exch. rate  on cash flows.  So, economic exposure is about the  in PV of CF as a result of  in exchange rates.  Economic exposure  simply, impact of exchange rate  on future cash flows. 2 components Econ. Exposure Operating Exposure Transaction Exposure 8

Measuring Economic Exposure (cont’d)  We’ve already seen that transaction exposure stems from exchange gains or losses on foreign currency denominated contractual obligations.  Though transaction exposure is included in accounting exposure, it really is economic exposure since contractual obligations mean  in future transaction cash flows.  Operating exposure arises because currency fluctuations can alter a company’s revenues and costs – i.e. operating cash flows.  Thus, operating exposure is much more comprehensive and long term in nature (unlike transaction exposure that measures  in CF due to individual transactions). It is far more pervasive. 9

Measuring Economic Exposure (cont’d)  Operating Exposure  views the firm as an ongoing concern with operations whose cost and price competitiveness could be affected by exchange rate  s.  The firm faces operating exposure the moment it invests in servicing a market subject to foreign competition  or in sourcing goods or inputs abroad.  i.e.  a firm could face operating exposure even if it has not invested abroad.  Since, economic exposure is much more comprehensive, it is more difficult to measure than accounting exposure. 10

Real and Nominal ER Changes  Before going on, recall from PPP the diff. between real and nom. exch. rate  s.  The distinction between real and nominal exch. rate  is important, since they have vastly different effects on economic exposure.  A  in relative price level should leave the real rate unchanged.  As long as real exchange rates have not , there should be no change in competitiveness and therefore very little  in economic exposure.  So, for economic exposure, what really matters is  in RER not  in NER. 11

Operating Exposure  A real exchange rate  affects a number of firm’s operations  and therefore induces operating exposure  it certainly leads to  in competitiveness.  The impact however depends on a number of factors:  Pricing flexibility (demand side)  Production flexibility (supply side)  Foreign subsidiary’s degree of competition  Extent of local inputs in production  Export dependence  ratio of exports to total sales 12

Operating Exposure (cont’d) (1) Pricing Flexibility :- Suppose HC appreciates, then obviously a domestic firm’s competitiveness is affected.  Profit margins in $ terms on both foreign and domestic sales could be squeezed  $ price of even domestic sales may be affected by now “lower priced imports”.  The extent of how badly a company could be squeezed will depend on it’s pricing flexibility and esp. its price elasticity of DD.  If the company’s products have low price elasticity (because its differentiated, or has snob appeal, or strong customer loyalty or produces an essential good and has “monopoly” power, etc.) then the co. has pricing flexibility.  Such a co. would be able to (a) keep the same $ price by  FC price (b) would not lose much market share to foreign competition both domestically and internationally, and so (c) will be able to maintain its long term $ profits and cash flow about the same. *The opposite is true for a co. with high price elasticity. 13

Operating Exposure (cont’d) (2) Production Flexibility (supply side)  The ability to shift production and the sourcing of inputs among countries can determine the extent to which a company would be susceptible to exchange risk.  The higher the production flexibility, the less the exchange risk.  Shifting production to (or sourcing inputs from) a country with depreciating currency or decreasing inputs from appreciating currency sources obviously helps  risk. 14

Operating Exposure (cont’d) (3) Foreign subsidiary’s degree of competition  For a company or MNC with a foreign subsidiary, the degree and type of competition (domestic & foreign) faced by the subsidiary can determine the economic exposure of the parent company.  If foreign subsidiary is producing and selling in the domestic market, a LC devaluation will hurt (via import content). But, if it is exporting, the LC devaluation effect is mitigated since the subsidiary’s export competitiveness will .  Likewise, with LC devaluation, the subsidiary’s foreign competitors exporting into the foreign subs. operating country will face price disadvantage  and therefore once again the effect of LC devaluation is mitigated. 15

Operating Exposure (cont’d) (4)Extent of Local Inputs  The higher the local input content in production, the greater the advantage of LC devaluation, since $ costs of production would be less. (5)Extent of Exports  LC devaluation, for a foreign subsidiary that exports most of products, could mean windfall profits, since export earnings will remain the same, if not increase (depending on demand elasticity), but production costs would be falling in $ terms following LC devaluation. 16

Operating Exposure (cont’d)  *The main conclusion of all this is that the following factors are far more important in determining a firm’s true economic exposure than that of any accounting definition:  the sector of the economy in which the firm operates (whether import–competing, exporting or selling non-traded items)  the sources of inputs (whether imported or local) and  the extent fluctuations in real exchange rate  For e.g., a company which produces cars based solely on domestic inputs for the domestic market would have zero accounting exposure, yet it would have extensive economic exposure since its competing against the Japanese and other foreign automakers. 17

The “Currency Habitat” Argument & 3 Illustrative Cases Summary Currency Habitat  1.Aspen Skiing  Revenues  $  Costs  $ No accounting exposure. Yet, the $ appreciation  revenues (Americans going to Alps - instead of Colorado Rockies - for skiing!) but kept costs the same  causing problems (economic exposure)  2.Petroleos Mexicanos  Revenues  $  costs  Peso (Accounting and economic exposures) Gains from $ appreciation and losses from $ depreciation. Costs in $ terms fall if $ appreciates (rise if $ depreciates)  3.Toyota Motor Company  Revenues  $ and ¥  ½ of cars exported to US. Costs  $ and ¥  steel, copper aluminum oil (inputs denom in $) Cost of imported inputs fall as yen appreciates; domestic costs stay the same; exports fall. Thus lower yen revenues and higher yen costs. Yen appreciation hurts Toyota, as profits drop 18

“Currency Habitat” Argument and Summary of the 3 Illustrative Cases (cont’d)  Where both revenues and costs are in multiple currencies the effect is ambiguous  it depends on exact breakdown by currency etc.  4.Suppose you had a 4 th Case where Revenue  in USD Cost  in EUR and if USD depreciates against EUR, this company will be in serious trouble, as revenue will fall with unchanged cost in euro terms (or unchanged revenue and rising cost in dollar terms) Conclusion:  Thus, the extent of economic exposure will depend on the currency habitat and which currency appreciates or depreciates.  Also, as in the case of Aspen Ski, you could have an entirely domestically oriented company that could have extensive economic exposure. 19

Calculating Economic Exposure  Recall that economic exposure is the  in PV of CF; thus, calculating economic exposure means estimating future cash flows and determining how these cash-flows would  when exchange rates .  This implies estimating cash-flows under diff. scenarios  where the scenarios  according to diff. assumptions of  in items like costs, product prices, revenues, etc.  As the input assumptions , the PV of CF computed under one scenario would differ from that of an earlier / diff scenario.  The assumptions are extremely important (assumption of price – elasticity, input mix, etc) in the calculation of CF . 20

Calculating Economic Exposure  So, in estimating economic exposure, you ask yourself how CF will , and what is the most likely scenario; the CF derived from the most likely scenario would then be “the best” estimate of the impact of economic exposure (worst-case, baseline, best-case).  Based on these likely scenarios and likely economic exposure, you ask yourself.  Is this project/foreign investment still worth the trouble? and;  If the investment has already been made, what action would you take to reduce the economic exposure?  Note: Accounting exposure (esp. translation) exposure is based on historical events, whereas economic exposure is forward looking by definition. 21

Measuring Exchange Risk  Since the measure of economic exposure (i.e -  in PV of CF) is dependent on the assumptions you make  it really involves a lot of judgment & intuition.  One workable way to determine a firm’s economic exposure without having to rely solely on assumptions is to examine historical data.  The basic idea is to determine the correlation between  in CF with  in nominal exchange rates.  This, by definition, means the said technique cannot be used for a brand new investment/proposed foreign venture. 22

An Operational Measure of Exchange Risk  A simple way to establish the correlation between CF and ER is through the use of a regression analysis. The regression model could be as follows: Where: = the $ value of total CF in period t = average NER during period t = random error with mean o. 23

An Operational Measure of ER Risk (cont’d)  The beta  measures the sensitivity of CF to exchange rate  s.  Higher the beta  the greater the sensitivity, higher the exposure.  Another regression output statistics that is important would be the R 2 stat  which measures the strength of the relationship.  a low R 2 means, the regression relation is unimportant in explaining CF  ’s due to exchange rate  s.  The major weakness with this technique is that it uses historical data.  A caution is in order: note that we are assuming the future would be pretty much like the past  may not be a great assumption. 24

25 MANAGING OPERATING EXPOSURE Operating exposure management requires long-term operating adjustments. A. Real vs Nominal Changes RER will not change if the NER change is offset fully by a change in price level (inflation), in which case there will be no gain/loss in competitiveness, and therefore will not alter CF. Surely, changes in RER will cause relative price changes: (i.e. prices of domestic goods relative to prices of foreign goods) – which will affect CF. Relative price changes lead to marketing and/or production revisions.

26 MANAGING OPERATING EXPOSURE (cont’d) B.Proactive Marketing and Production Initiatives Marketing: market selection pricing strategy product strategy production structure

MANAGING OPERATING EXPOSURE (cont’d) Market Selection  Appreciation of FC offers competitive advantage to, say, US goods in the foreign market  Select markets where the LC is strong or potentially strong vis- à-vis HC  Pick markets where foreign competitors likely to lose out if their currencies get stronger Pricing Strategy  Choice between market share and profit margin (go for bigger market share or bigger profit margin).  Depreciation of HC: the strategy is to either (a) raise HC prices and keep foreign price constant, to raise profit margin or (b) allow foreign prices to fall and increase market share  Much depends on price elasticity of DD and scale economies 27

MANAGING OPERATING EXPOSURE (cont’d) Product Strategy  HC depreciation provides opportunity to develop a brand franchise (competitive price advantage)  HC depreciation allows a firm to expand product line and cover a wider spectrum of consumers at home & abroad  HC appreciation may force a firm to target at up-end markets  Strong yen forced Japanese exporters to focus on more sophisticated, high-value products that are less sensitive to price increases caused by yen appreciation 28

MANAGING OPERATING EXPOSURE (cont’d)  Production Structure  HC appreciation may be accompanied by shifting the manufacturing base overseas (e.g. German & Japanese automakers)  Alternatively, change the input mix by buying more components overseas (outsourcing by US firms)  MNCs may opt for shifting production among plants in different country locations, diversification to reduce operating exposure (Japanese car manufacturers)  HC appreciation would force firms to raise productivity (closing down of inefficient plants; employee motivation, slashing variety) 29

SUMMARY & CONCLUSIONS *Accounting profession’s focus on balance sheet impact of exchange rate changes bypasses the more important impact on future cash flows, *Real, not nominal, exchange rates hold the key to measuring economic exposure. *The impact of exchange rate changes on a firm depends on many variables such as the location of its major markets and competitors, supply and demand elasticity, substitutability of inputs (local against foreign) and offsetting inflation. *Since currency risk affects all facets of a company’s operations, it should not be the concern of financial managers alone. 30

SUMMARY & CONCLUSIONS (cont’d) * Operating managers have to develop marketing and production initiatives so as to ensure long-run profitability. * The key to effective exposure management is to integrate currency considerations into the general management process. * In an integrated exchange risk programme, the role of financial executive is to (a) provide forecasts of inflation and exchange rates; (b) identify and highlight the risks of competitive exposure; (c) estimate and hedge the remaining operating exposure (after the above-mentioned efforts) 31

END OF LECTURE 8 Be Cool, Stay Calm, No Worries! 32