8/26/14
INTERNATIONAL
FINANCIAL
MANAGEMENT
Seventh Edition
EUN / RESNICK
Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
9-0
Management of
Economic Exposure
Chapter Objective:
9
Chapter Nine
INTERNATIONAL
FINANCIAL
MANAGEMENT
This chapter provides a way to measure economic
exposure, discusses its determinants, and presents
Fourth
Third Edition
methods for managing and hedging economic
EUN / RESNICK
exposure.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
9-1
Chapter Outline
l
Three Types of Exposure
u Economic
l
Economic Exposure:
n
n
l
vs. Transaction vs. Translation
Measurement
Management
Operating Exposure:
Definition & Illustration
Determinants
n  Management
n
n
9-2
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Three Types of Exposure
l
Economic
vs. Transaction
vs. Translation
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Three Types of Exposure
l
Economic Exposure
n
l
Transaction Exposure
n
l
Exchange risk as applied to the firm’s competitive
position. The subject of this Chapter (#9).
Exchange rate risk as applied to the firm’s home
currency cash flows. The subject of Chapter 8.
Translation Exposure (NOT Exam Material)
n
9-4
Exchange rate risk as applied to the firm’s
consolidated financial statements. The subject of
Chapter 10.
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1. Economic Exposure
Exchange rate risk as applied to the firm’s
competitive position.
l  Any anticipated changes in the exchange rates
would have been already discounted and reflected
in the firm’s value.
l  Economic exposure can be defined as the extent to
which the value of the firm would be affected by
unanticipated changes in exchange rates.
l
9-5
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Economic Exposure (continued)
l
Changes in exchange rates can affect
n
n
l
firms directly engaged in international trade
purely domestic firms*
* Examples
n
US bike manufacturer who sources/sells only in the USA
u Since
n
the firm’s product competes against imported bicycles
à it is subject to foreign exchange exposure.
High-end ski slope operator in the Alps
u Even
if the clientele is overwhelmingly from the EU, most of
those customers will cross-shop with the Rockies or Andes.
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9-6
2. Transaction Exposure
l
l
This is the subject of Chapter 8.
Definition
sensitivity of the “realized” domestic currency values
of a firm’s contractual cash flows denominated in
foreign currencies
n  to unexpected exchange rate changes.
n
l
Transaction exposure arises from fixed-price
contracting in a world of constantly changing
exchange rates.
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9-7
Translation Exposure
(Not Exam Material)
l
l
The subject of Chapter 10.
Definition
n
Exchange rate risk as applied to the firm’s consolidated
financial statements.
u Consolidation
involves translation of subsidiaries’ financial
statements from local currencies to home currency.
l
Involves many controversial issues.
9-8
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3. Economic Exposure
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9-9
How to Measure
Economic Exposure
l
Economic exposure is the sensitivity
of (i) the future home currency value of the firm’s
assets and liabilities and (ii) its operating cash flow
n  to random changes in exchange rates
Investor’s perspective: Sensitivity of the future homecurrency values of the firm’s assets and liabilities to
random changes in exchange rates
n
l
n
l
Statistical measurement : regressions of stock price on FX rate
Manager’s perspective: Sensitivity of firm’s operating
cash flows to random changes in exchange rates
n
Hard to measure: sales are endogenous à regressions ill advised
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
9-10
Channels of Economic Exposure
Asset exposure
Home currency
value of assets and
liabilities
Exchange
rate
fluctuations
Operating exposure
9-11
Firm
Value
Future operating
cash flows
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3a. Asset Exposure
(3a is NOT Exam Material)
9-12
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How to Measure
Economic (Asset) Exposure
l
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
P = a + b×S + e
a is the regression constant
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.
9-13
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How to Measure
Economic (Asset) Exposure
The exposure coefficient, b, is defined as follows:
b=
Cov(P,S)
Var(S)
Where Cov(P,S) is the covariance between the dollar
value of the asset and the exchange rate, and Var(S)
is the variance of the exchange rate.
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How to Measure
Economic (Asset) Exposure
l
The exposure coefficient shows that there are two
sources of economic exposure:
1.  the variance of the exchange rate and
2.  the covariance between the dollar value of the asset
and exchange rate
b=
Cov(P,S)
Var(S)
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9-15
How to Measure
Economic (Asset) Exposure
l
Technical issues with the regression analysis
(NOT Exam Material)
n
Endogeneity problem?
n
Non-stationarity of the stock price & FX time series?
u Levels
n
vs. differences
Time-varying variance?
u (G)ARCH
9-16
modeling?
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Asset Exposure: A Simple Example
Suppose a U.S. firm has an asset in Britain whose
local currency price is random
l  For simplicity, suppose there are only three states
of the world & each state is equally likely to occur
l  Finally, suppose that (1) the future local currency
price of this British asset, say P*, and (2) the
future exchange rate, say S, will be determined
depending on the realized state of the world
l
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Example (continued)
State
Probability
P*
S
S×P*
1
1/3
£980
$1.40/£
$1,372
2
1/3
£1,000
$1.50/£
$1,500
3
1/3
£1,070
$1.60/£
$1,712
1
1/3
£1,000
$1.40/£
$1,400
2
1/3
£933
$1.50/£
$1,400
3
1/3
£875
$1.60/£
$1,400
1
1/3
£1,000
$1.40/£
$1,400
2
1/3
£1,000
$1.50/£
$1,500
3
1/3
£1,000
$1.60/£
$1,600
Case 1
Case 2
Case 3
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9-18
Example (continued)
l
In case one, the local currency price of the asset
and the exchange rate are positively correlated.
n
n
This gives rise to substantial exchange rate risk.
Example? Cartier?
State
Probability
P*
S
S×P*
1
1/3
£980
$1.40/£
$1,372
2
1/3
£1,000
$1.50/£
$1,500
3
1/3
£1,070
$1.60/£
$1,712
Case 1
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9-19
Example (continued)
l
In case two, the local currency price of the asset
and the exchange rate are negatively correlated.
This ameliorates (i.e., reduces) the exchange rate risk
substantially – completely, in this example.
n  Example?
n
State
Probability
P*
S
S×P*
1
1/3
£1,000
$1.40/£
$1,400
2
1/3
£933
$1.50/£
$1,400
3
1/3
£875
$1.60/£
$1,400
Case 2
9-20
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Example (continued)
l
In case three, the local currency price of the asset
is fixed at £1,000
n
n
This “contractual” exposure can be completely hedged.
Realistic? Electric utility? Health Care?
State
Probability
P*
S
S×P*
1
1/3
£1,000
$1.40/£
$1,400
2
1/3
£1,000
$1.50/£
$1,500
3
1/3
£1,000
$1.60/£
$1,600
Case 3
9-21
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3b. Operating Exposure
(Back to Exam Material)
9-22
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Operating Exposure: Definition
The effect of random changes in exchange rates
on the firm’s competitive position, which is not
readily measurable.
l  A good definition of operating exposure is
the extent to which the firm’s operating cash
flows are affected by the exchange rate.
l
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How to Measure
Economic (Operating) Exposure
l
Should we use regression analysis?
n
Endogeneity
u Sales
l
are a key decision variable of managers
From the manager’s perspective, what matters?
Changes in the competitive position relative to foreign
competitors
n  We know how to measure this: RER (“relative PPP”)
n
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9-24
Economic (Operating) Exposure and
Real Exchange Rate
The real exchange rate index = q* =
s’t+T
s’t
If PPP holds, then s’t+T = s’t so q* = 1.
q* < 1 à foreign country’s competitiveness improves
(and U.S. competitive position worsens);
q* > 1 à foreign country’s competitiveness worsens
(and U.S. competitiveness improves).
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9-25
Determinants of Operating Exposure
Recall that operating exposure cannot be readily
determined from the firm’s accounting
statements as can transaction exposure.
l  The firm’s operating exposure is determined by:
l
n The
market structure of inputs and products: how
competitive or how monopolistic the firm’s markets are
n Example:
Latest export statistics for the Eurozone
n The
firm’s ability to adjust its markets, product mix,
and sourcing in response to exchange rate changes.
9-26
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Managing Operating Exposure
(i) Selecting Low Cost Production Sites
l  (ii) Flexible Sourcing Policy
l  (iii) Diversification of the Market
l  (iv) R&D and Product Differentiation
l  (v) Financial Hedging
l
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9-27
(i) Low-Cost
Production Sites
l
A firm may wish to diversify the location of their
production sites to mitigate the effect of exchange
rate movements.
n  e.g.
Honda built North American factories in (partial)
response to a strong yen, but later found itself
importing more cars from Japan due to a weak yen.
n  Danger of losing economies of scale from too many
production sites
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9-28
(ii) Flexible Sourcing Policy
l
Sourcing does not apply only to components, but
also to “guest workers”.
n  e.g.
Japan Air Lines hired foreign crews to remain
competitive in international routes in the face of a strong
yen, but later contemplated a reverse strategy in the face
of a weak yen and rising domestic unemployment.
9-29
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(iii) Diversification of the Market
l
Selling in multiple markets to take advantage of
economies of scale and diversification of
exchange rate risk.
9-30
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(iv) R&D and Product Differentiation
l
Successful R&D that allows for
cost cutting
enhanced productivity
n  product differentiation.
n
n
l
Successful product differentiation gives the firm
less elastic demand—which may translate into less
exchange rate risk.
9-31
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(v) Financial Hedging
The goal is to stabilize the firm’s cash flows in
the near term.
l  Financial Hedging is distinct from operational
hedging.
l  Financial Hedging involves use of derivative
securities such as currency swaps, futures,
forwards, currency options, among others.
l
9-32
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End Chapter Nine
9-33
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