1. Assessing Exchange Rate Risk: Part II Exchange Rate Exposure

2. www.blades.com BLADES Board & Skate arrived on the action / extreme scene in 1990, and quickly became a trusted source of equipment and service to in-line skaters, skateboarders, and snowboarders. BLADES got its start in New York and currently operates 15 retail stores in New York, New Jersey, Massachusetts and Pennsylvania.

3. Increasing competition and rising costs have lowered Blades’ profit margins Blades could cut costs by importing lower cost components from Thailand

4. Suppose that Blades makes an agreement to buy plastic components sufficient to produce 72,000 pairs of rollerblades from Thai manufacturers at a price of THB 2,870 per pair. ($1 = THB 38.87). Payment is due in one month (72,000*2,870 = THB 206.64 M) Trend

5. THB 2,870 per pair (THB 1 = $.0257) Should Blades import components from Thailand? $75 Per Pair THB 2,870 (.0257)= $73.75 $75 - $73.75 $75 100 = 1.6% At the current exchange rate, Blades could cut their costs by 1.6% by importing from Thailand (a savings of $90,000)!!

6. However, importing Thai components creates a transaction exposure for Blades THB 2,870 per pair (THB 1 = $.0257) Costs ($) = e ($/THB) * 72,000* Costs (THB) Constants Random Variable We need to estimate this!!

7. Regression Results VariableCoefficientsStandard Errort Stat Intercept. 80.0240 Inflation.80.352.28 Regression Statistics R Squared.43 Standard Error2.20 Observations240 Every 1% difference between US inflation and Thai inflation depreciates the dollar by.8%

8. US inflation is currently 1% (per month) while inflation in Thailand is 2.25% (per month) =.8 + 0.80 * (inf) + error (1 – 2.25) = -1.25 Mean =. 80 Std. Dev. =.02 Mean =.80 Std. Dev. =. 35 Mean = 0 Std. Dev. = 2.20 Forecast Mean = -.2% Std. Dev. = 2.25% Your 95% confidence interval for the (monthly) percentage change in the exchange rate is [-4.7%, 4.3% ] % Change in e ($/THB )

9. Forecast (% Change) Mean = -.2% Std. Dev. = 2.25% Assessing transaction exposure Costs ($) = e ($/THB) * 72,000*2,870 THB THB 2,870 per pair (THB 1 = $.0257) Costs Mean = 72,000*2,870*.0257(1-.002) = $5,300,026 Std. Dev. =.0225*72000*2870*.0256 = $119,250 (2.25%)

10. Assessing transaction exposure Costs ($) = e ($/THB) * 72,000*2,870 THB You are 95% sure your costs will be between: $5,300,026 + 2*$119,250 = $5,538,526 and $5,300,026 - 2*$119,250 = $5,061,526 THB 2,870 per pair (THB 1 = $.0257) Mean = $5,300,026 Std. Dev. = $119,250

11. THB 2,870 per pair (THB 1 = $.0257) Should Blades import components from Thailand? $75 Per Pair Mean = $5,300,026 Std. Dev. = $119,250 Mean = $5,400,000 Std. Dev. = $0 What do you do?

12. Blades is also thinking about exporting rollerblades to Thailand

13. Suppose that Blades makes an agreement to sell 30,000 pairs of roller blades to a Thai sporting goods store for THB 4,500 apiece. Trend

14. Forecast (% Change) Mean = -.2% Std. Dev. = 2.25% Assessing transaction exposure Net Cash Flows($) = e ($/THB) * ( 72,000*2,870 - 30,000*4,500) Net Cash Flows($) Mean = 71,640,000*.0257(1-.002) = $1,837,465 Std. Dev. =.0225*71,640,000*.0257 = $41,342 (2.25%) = e ($/THB) * ( 71,640,000THB)

15. Blades could also import Japanese components. Japanese components are slightly more expensive (Y 8,000 per pair = $74.77) $1 = Y 107

16. Suppose that Blades splits its purchases of components between Thailand and Japan (Exports to Thailand = 0) THB 2,870 per pair (THB 1 = $.0257) JPY 8,000 per pair (JPY 1 = $.0093) THB 2,870*.0257*36,000 = $2,655,324 JPY 8,000*.0093*36,000 = $2,678,400 $5,333,724

17. $2,678,400 $5,333,724 Forecast (% Change) Mean = 0% Std. Dev. = 2.25% Forecast (% Change) Mean = 0% Std. Dev. = 3.50% $2,655,324 $5,333,724 =.49=.51 CORR = -.65 Net Cash Flows

18. Cash flow Situation… And the Currencies are… Currency exposure Equal Inflows of Two CurrenciesPositively CorrelatedHigh Equal Inflows of Two CurrenciesUncorrelatedModerate Equal Inflows of Two CurrenciesNegatively CorrelatedLow Inflow in one currency/outflow in anotherPositively CorrelatedLow Inflow in one currency/outflow in anotherUncorrelatedModerate Inflow in one currency/outflow in anotherNegatively CorrelatedHigh Importing from both Japan and Thailand can diversify currency exposure!!

19. Suppose that Blades is planning to expand sales into England. Should they try and contract sales in dollars or Pounds? Current GBP 1 = $1.80 Forecast (% Change) Mean = 0 SD = 2.0% Contracting sales in GBP creates transaction exposure. However, contracting sales in USD creates economic exposure

20. Suppose that Blades agrees to sell roller blades to England for $125 apiece. (GBP 70) Current GBP 1 = $1.80 Forecast (% Change) Mean = 0 SD = 2.0% Demand in England is as follows: Q = 400 - 3P P = Local price of Roller blades At a local price of GBP 70, demand equal 500 - 3(70) = 190

21. Elasticity of Demand refers to the responsiveness of demand to price changes (here, the price is the interest rate) Q = 500 – 3P # Roller Blades P 190 70 1% 1.1%

22. Suppose that Blades agrees to sell roller blades to England for $125 apiece. (GBP 70) Current GBP 1 = $1.80 Forecast (% Change) Mean = 0 SD = 2.0% Revenues = Price ($) * Quantity Constant Forecast (% Change) Mean = 0 SD = 2.0%*Elasticity = 2.2%

23. Revenues = Price ($) * Quantity Constant Forecast (% Change) Mean = 0 SD = 2.0%*Elasticity = 2.2% Revenues = e ($/L)* Price (L) * Quantity Constant Forecast (% Change) Mean = 0 SD = 2.0 GBP Pricing (Transaction Exposure) USD Pricing (Economic Exposure)

24. Changes in currency prices can have all kinds of economic impacts. A more general way to estimate economic exposure would be as follows: Percentage change in the exchange rate ($/F) Percentage change in cash flows (measured in home currency)

25. Regression Results VariableCoefficientsStandard Errort Stat Intercept.051.5.03 % Change in Exchange Rate -3.35.97-3.45 Regression Statistics R Squared.63 Standard Error1.20 Observations1,000 Every 1% depreciation in the dollar relative to the British pound lowers cash flows from England by 3.35%

26. Suppose that Blades sets up a Thai subsidiary. The Thai plant uses locally produced components to produce roller blades that will be sold to local (Thai) customers. Is Blades still exposed to currency risk?

27. Blades will need to produce consolidated cash flow and income statements as well as a consolidated balance sheet. Translation exposure refers to the impact of exchange rate changes on these financial statements. FASB Rule #52 (for US Based MNCs)  The functional currency of an entity is the currency of the economic environment in which the entity operates  The current exchange rate as of the reporting date is used to translate assets/liabilities from the functional currency to the reporting currency  The weighted average exchange rate over the relevant reporting period is used to translate revenues, expenses, gains, and losses  Translated Gains/Losses are not recognized as current net income, but are reported as a second component of stockholders’ equity Should we be worried about this type of exposure??

28. Examples of translation exposure CompanyCitigroup General Motors Wall Mart Net Income (2004) $17.04B$3.8B$9B Income Gains/Losses due to currency changes $731M (4.3%) $929M (24%) $320M (3.5%)