1. Multinational Financial Management Alan Shapiro 7th Edition J
Multinational Financial Management Alan Shapiro 7th Edition J.Wiley & Sons
Power Points by
Joseph F. Greco, Ph.D.
California State University, Fullerton

2. MEASURING AND MANAGING ECONOMIC EXPOSURE
CHAPTER 11
MEASURING AND MANAGING ECONOMIC EXPOSURE

3. 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

4. PART I. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
A. Economic exposure
focuses on the impact of currency
fluctuations on firm’s value.
1 . Expectations about the fluctuation must be incorporated in all basic
decisions of the firm.

5. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
2. Definitions:
a. Accounting exposure
impact on firm’s balance sheet
b. Economic exposure
1.) Transaction
2.) Operating

6. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
THE REAL EXCHANGE RATE

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

8. 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 real exchange rate.
b. It is the relative price changes that ultimately determine a firm’s long-run exposure.

9. PART II. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES
II. ECONOMIC CONSEQUENCES
A. Transaction exposure
1. On-balance sheet
2. Off-balance sheet

10. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES
II. ECONOMIC CONSEQUENCES (con’t)
B. Operating Exposure : real rate change
1. Pricing flexibility is key
2. Product differentiation
3. Substitution of inputs

11. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES
II. SUMMARY
The sector of the economy in which the
firm operates;
the sources of the firm’s inputs;
and
fluctuations in the real exchange rate
delineate the firm’s true economic
exposure.

12. PART III. IDENTIFYING ECONOMIC EXPOSURE
III. CASE STUDIES OF ECONOMIC EXPOSURE
A. ASPEN SKIING COMPANY
1. Firm’s exchange rate risk affected its sales revenues.

13. IDENTIFYING ECONOMIC EXPOSURE
A. ASPEN SKIING COMPANY (con’t)
2. Although there was no translation
risk, the global market with its exchange rate risk and its competitors impacted market demand.

14. IDENTIFYING ECONOMIC EXPOSURE
B. PETROLEOS MEXICANOS (PEMEX)
1. The firm’s exchange rate risk
affected cost but not revenues.
2. Economic impact
a. Revenues: none
b. Costs: decreased
c. Net effect: increased US$ flows

15. IDENTIFYING ECONOMIC EXPOSURE
C. TOYOTA MOTOR COMPANY
1. Exchange rate risk affected BOTH
revenues and costs.
2. Flow back effect:
previously exported goods return
with increased domestic competition.
3. Lower profit margins domestically

16. PART IV. CALCULATING ECONOMIC EXPOSURE
IV. A quantitative assessment of economic
exposure depends on underlying assumptions concerning:
A. future cash flows;
B. sensitivity to exchange rate
changes.

17. PART V. AN OPERATIONAL MEASURE OF EXCHANGE RISK
V. NEED FOR A WORKABLE APPROACH
A. Regression Analysis
1. Variables
a. Independent:
changes in parent’s cash flows
b. Dependent:
Average nominal exchange rate change.

18. AN OPERATIONAL MEASURE OF EXCHANGE RISK
B. REGRESSION EQUATION
-approach based on the operational definition of the exchange risk faced by a parent or one of its affiliates:
-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

19. AN OPERATIONAL MEASURE OF EXCHANGE RISK
where CFt = CFt - CFt-1 and
CFt is the dollar value of total affiliate(parent)cash flows in period t
EXCHt = EXCHt - EXCHt-1 equals the average nominal exchange rate during period t
u = a random error term

20. AN OPERATIONAL MEASURE OF EXCHANGE RISK
1. Output measures:
a. Beta coefficient (b)
measures the association of changes in cash flows to exchange rate changes.

21. AN OPERATIONAL MEASURE OF EXCHANGE RISK
b. the higher the percentage change of cash flow to changes in exchange rates, the greater the economic exposure (higher beta values).

22. AN OPERATIONAL MEASURE OF EXCHANGE RISK
VI. SUMMARY:
A. The focus of the accounting profession on the balance sheet impact of currency changes has led to ignoring the important impact on future cash flows.

23. AN OPERATIONAL MEASURE OF EXCHANGE RISK
B. For firms incurring costs and selling products in foreign countries, the net effect of currency changes may be less important in the long run.

24. AN OPERATIONAL MEASURE OF EXCHANGE RISK
C. To measure exposure properly, you must focus on inflation-adjusted or real exchange rates instead of nominal or actual exchange rates.

25. AN OPERATIONAL MEASURE OF EXCHANGE RISK
D. It is difficult in practice to determine what the actual economic impact of a currency change will be.

26. PART VI. MANAGING OPERATING EXPOSURE
I. INTRODUCTION
Operating exposure management requires
long-term operating adjustments.
A. Real v. Nominal Changes
1. Relative price changes
leads to marketing and/or
production revisions

27. MANAGING OPERATING EXPOSURE
B. Proactive Marketing and Production
Initiatives
1. Marketing:
market selection
product strategy
pricing strategy
promotional strategy

28. MANAGING OPERATING EXPOSURE
B. Proactive Marketing and Production
Initiatives (con’t)
2. Production:
product sourcing
input mix
plant location
raising productivity

29. MANAGING OPERATING EXPOSURE
II. Marketing Management Adjustments
A. Market Selection
1. use advantage to carve out market share
2. Market segmentation

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

31. MANAGING OPERATING EXPOSURE
3. Following HC depreciation, local
firm may have much more freedom in its pricing.
C. Promotional Strategy

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

33. MANAGING OPERATING EXPOSURE
III. Product Management Adjustments
product sourcing and plant location are the principal variables to manipulate.
A. Input mix
B. Shift production among plants
C. Plant location
D. Raising productivity

34. MANAGING OPERATING EXPOSURE
IV. Planning For Exchange-Rate Changes
A. With better planning and more competitive options, firms can change strategies substantially
B. before the impact of an currency change makes itself felt.
C. Implication: compaction of adjustment period following an exchange-rate change.

35. MANAGING OPERATING EXPOSURE
V. Financial Management of Exchange Rate Risk: Financial manager’s Role in Marketing and Production
A. Provide local manager with fore-
casts of inflation and exchange-
rate changes.
B. Identify and focus on competitive exposure.

36. MANAGING OPERATING EXPOSURE
C. Design the evaluation criteria so that operating managers neither
rewarded or penalized for
unexpected exchange-rate
changes.
D. Estimate and hedge the operating
exposure after adjustments made.