Classnote
Prof. Gordon Bodnar
Corporate Exposure to Exchange Rates
Definitions
Broadly speaking, we can classify the impact of exchange-rate changes on the firm into three effects:
Translation Exposure: This exposure is the basis of the accounting based exchange rate gains or losses that
results from converting foreign currency financial statements of foreign affiliates into parent currency units
plus the conversion of FC items on the parent balance sheet. It arises from the total change in the nominal
exchange rate from the previous reporting period and the particular accounting basis (defined by the
consolidation method used). As this gain or loss is unrealized, translation effects do not result in a change
in current cash flow. Except in limited cases, from a cash flow perspective, management of translation
effects is not justifiable.
Transaction Exposure: This exposure measures the value of outstanding nominal foreign currency financial
receivables or payables incurred prior to an exchange rate change but not due to be settled (for cash) until
after the exchange rate change. This is a result of the unexpected component of nominal exchange-rate
changes. Transaction exposures have an impact on current cash flows.
Operating Exposure: This exposure measures the impact of the exchange rate on the value of the flow of future
transactions resulting from changes in real exchange rates and the corresponding changes in relative
competitiveness.
Translation Exposure - In previous lectures, the source of this exposure was determined to arise from how the
accounting rules require us to convert foreign currency items on parent balance sheets into parent currency and
convert foreign affiliate’s foreign currency financial statements into parent currency.
Transaction Exposure - Transaction exposure arises from unexpected changes in nominal exchange rates
when:
1.
Purchasing/selling goods or services on credit with foreign currency prices.
2.
Borrowing or lending funds when repayment is to be made in a foreign currency.
3.
Otherwise acquiring contractual nominal positions denominated in foreign currency.
Example 1: Sale of Goods on Credit
A U.S. firm sells goods to a foreign buyer with price of $10,000, with payments due in 90 days. The current
spot price is S(FC/$) = 3.00, so the price of the sale in foreign currency is FC 30,000. The transaction exposure
arises because in all likelihood the foreign buyer will probably not pay FC 30,000 because the spot rate will differ on
the settlement date.
Consider:
if S(FC/$)t+90 = 4 the foreign buyer pays FC 40,000
if S(FC/$)t+90 = 2 the foreign buyer pays FC 20,000
Thus, the foreign buyer faces an economic gain or loss on the purchase of the goods depending on how the
exchange rate changes. Notice that if the contract price had been set in foreign currency, the U.S. producer would
face the transaction exposure rather than the foreign buyer.
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Corporate Exposure to Exchange Rates
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Example 2: Borrowing in Foreign Currency:
A UK firm borrows SF100,000 from a bank for 1 year. At the time of the borrowing, S(SFr/£) = 10, so UK firm
borrowed £10,000. Ignoring the interest payments at the time of the repayment of principal:
if S(SF/£) = 12, the pound cost of repayment of principal = £8,333 and the firm experiences a gain of £1,666
if S(SF/,) = 8, the pound cost of repayment of principal = £12,500 and the firm experiences a loss of £2,500
Thus, the UK firm faces an exchange rate gain or loss (in pounds) depending on the change in the (SF/£)
nominal exchange rate.
It must be noted that transaction exposure arises in every international transaction. Either the buyer or the seller
will face a transaction exposure. Both will face transaction exposure if they contract in a third currency. Thus, part
of the negotiation of international transaction will include the currency of payment and which party will bear the
transaction exposure. Ideally, the party best able to bear (manage) the risk will find it in their interest to take on the
transaction exposure. In doing so, presumably, they can negotiate a slightly better deal out of the counterparty.
Differences between Economic and Accounting Transaction Exposure
Transaction gains or losses result in changes in actual cash flows. In this sense, transaction exposures are cash
flow exposures that have a direct impact on firm value. However, the economic measure of transaction exposure
differs in two important ways from the accountants’ measure of transaction exposure that we discussed previously
and demonstrated above.
The first difference between the economic transaction exposure and the accounting transaction exposure is the
timing of the exposure. Economically the transaction exposure arises the moment the firm enters a FIXED
NOMINAL FOREIGN CURRENCY CONTRACT. That is, whenever it commits to pay or receive a specific
amount of foreign currency as part of a transaction at some date in the future. Thus, the economic exposure begins
not when the transaction is entered into the books (typically when the good is shipped to or received by the buyer)
but when the agreement is reached and the terms set for the transaction to occur. This date is typically called the
commitment date. The economic definition of transaction exposure differs from the accounting definition in that the
actual cash flow impact of exchange rate changes on the value of the transaction begin from the commitment date
rather than the transaction date (which is when the accountants enter the transaction into the books).
A second difference is the definition of exchange rate change that generates the gain/loss on an economist’s
measurement of transaction exposure compared to the exchange rate change that generates the gain/loss on the
accountants’ measurement of transaction exposure. Under the accountant’s definition, the transaction is originally
recorded the spot exchange rate on the transaction date and closed using the exchange rate on the settlement date.
Thus, the exchange rate gain/loss is a function of the total nominal exchange rate change between these two dates.
However, from an economic standpoint, this makes no sense. If I am setting a price today in foreign currency,
knowing that I will not receive/pay foreign currency for say, ninety days in the future, why would I worry about the
current exchange rate? I should be making my pricing decision based upon the expected value/cost of the
transaction in 90 days. Thus, my decision regarding this transaction should be based upon my expectation of the
exchange rate in 90 days—not upon the current exchange rate. Put another way, I should be taking into account all
the exchange rate change expected to occur between now and the settlement date when deciding on the price with
which I will enter into the transaction. Ultimately I am concerned about the amount I am expecting to receive/pay
on settlement, not how much the transaction is worth today. It is the present value of the expected cash flow that
matters for firm value, not the value of that foreign currency cash flow at today’s spot rate. The spot rate is
irrelevant as the cash flow is not occurring today. Thus, the second important difference is that economic transaction
exposure is based upon UNEXPECTED nominal exchange rate changes not the actual nominal exchange rate
changes as the accountants measure it.
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Corporate Exposure to Exchange Rates
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Example:
On September 1, a U.S. firm agrees to a contract to provide a specialized computer chip to an Italian firm. The
agreement specifies that the U.S. firms must design, build and ship 1000 of these made-to-order chips within 180
days and that the Italian firm will make payment to the U.S. firm in the amount of Lit 2.5b within 180 days of
receiving the chips.
The current exchange rates are S(Lit/$)t = 1200, S(Lit/$)t+180 = 1250 and S(Lit/$)t+360 = 1400
What is the value of this transaction to the U.S. firm?
The U.S. firm will receive Lit2.5b in 360 days. The current value of this inflow is the present value of Lit 2.5b
x S($1/Lit1400) = $1.786m Note that this expected value has nothing to do with the current spot rate or the
exchange rate on the transaction date. The transaction exposure the U.S. firm faces is the difference between the this
amount, $1.786m, and the amount of dollars they actually receive which will be Lit2.5b times the actual spot rate on
the settlement date. Thus, the economic transaction exposure arises from the date that the Lit price is set (September
1) and the size of the transaction gain or loss will be the product of Lit 2.5b and the deviation of the actual S(Lit/$)
rate in 360 days from the expected S(Lit/$) rate in 360 as of September 1.
The important managerial implication of this point is that when setting the foreign currency contract price, the
firm should not be concerned about the current spot price, but rather the expected future spot price when it
receives/makes payment in foreign currency. The firm should take into account any expected change in the nominal
exchange rate in determining the expected revenue/cost associated with the contract. Given the expectational
equilibrium in the market the expected future spot price is approximated by the forward rate. Thus, the firm should
be making international pricing decisions using the forward rate curve rather than the spot rate.
Summary for Transaction Exposure
•
If you are holding a foreign denominated net asset position, you gain from an unexpected depreciation of
the home currency
•
If you are holding a foreign denominated net liability position, you gain from an unexpected appreciation of
the home currency.
Operating Exposure
The effects of operating exposure are more important for the financial position of the firm than the effects of
transaction exposure. However, unlike transaction exposure, which is easily identified (directly from looking at the
transaction contracts), operating exposure is somewhat subjective: it depends on assessing the impact of exchangerate changes on transactions into which the firm has not yet entered. To determine operating exposure it is necessary
to measure the change in the expected future cash flows of the firm in response to changes in the exchange rate.
Since prices have not been set for future transactions, operating exposure depends not on changes in nominal
exchange rates, but on changes in real exchange rates. As with transaction exposure, operating exposure should
only be a function of unexpected changes in the real exchange rate as expected changes should be incorporated into
current expectations about future firm performance (i.e. current market valuation). However, under relative PPP the
expected change in the real exchange rate is zero. Under absolute PPP, the change in the exchange rate is
determined by its movement back toward the assumed equilibrium. Unless there is large sudden devaluation, this
typically happens slowly. However, to the extent that deviations from PPP are expected to cause real exchange rate
changes over the medium term, the firm should incorporate these expectations into its pricing, production, and
location decisions and should be prepared for such movements.
It is important to be aware that just about every firm conceivably has some operating exposure to exchange
rates. The size and sign of a firm’s operating exposure will be a function of several factors: the activities in which it
participates (such as exporting, importing, foreign investments etc.), the nature of the competition it faces (such as a
perfectly competitive output market or an oligopolistic output market where firms have some market power), and the
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p. 3
structure of the markets for its factors of production. However, it is impossible to generalize about how all these
factors interact to determine exposure.
Therefore, to begin, let us consider a simple situation where firms produce homogeneous goods in a competitive
international market with non-traded locally sourced inputs. In this case, the quantity sold will not matter as the
markets are perfectly competitive and the quantity of any given firm is indeterminant (we can take it to be one). This
case will also clearly demonstrate the difference between short run and long run effects. These effects are more
difficult to see in a more realistic model. To make the operating exposure clear, assume that all transactions are
carried out on a ‘cash at transaction’ basis, so transaction exposure is non-existent.
Operating Exposure in Simple Competitive Example
Initially, assume the price of foreign currency (FC) in terms of home currency (HC) is S(HC/FC) = 1.0
Consider a home country exporting firm that produces a homogeneous good
•
•
•
•
•
•
•
the world-market determined price of the good is FC 10 => local price is HC 10
the firm has a HC cost of production (consisting of labor and inputs) of HC 9
net cash flow to the firm is HC 1
the required rate of return to this activity is 10%
the home country price level is 1.00
foreign firms produce the same good at a cost of FC 9 and have the same required rate of return
there are no barriers to trade and transportation costs are zero
Home firms that sell their good in the foreign market will be called exporters. Firms that sell their good in the
home market will be called import competitors (a firm that competes in the home market with the imports from
foreign firms).
If the home firm exports its good, it sells the good for FC 10 which it converts into HC 10 at the current
exchange rate of S(HC/FC) = 1. If it sells in the home market, then it sells its good for HC 10. In either case, with
costs of HC 9, the firm makes a net cash flow of HC 1 and its firm value is V0. With this cash flow expected into
perpetuity and no expected inflation, the value of the firm given the required rate of return (10%) V0 is 10, and the
real value of the firm, V0/P0= 10.
Now consider the effect of an unexpected 10% depreciation of the HC.
• the exchange rate rises to S(HC/FC) = 1.1.
What will be the impact on the firm value of the exporting firms in this industry?
• with competitive markets and unchanged foreign costs, the price for the good is still FC 10
• when the firm sells a good at FC 10 and converts into HC it now receives 11
• with home country costs of production still at HC 9 (in the short run), the cash flow to the firm rises to HC
2 raising firm value to V1 (V1 > V0)
• with no inflationary expectations, and current cash flows the firm value, V1 rises to 20, and real firm value
also rises (not quite to 20 as there has been some price level increase already).
Since a firm is free to sell its goods in either the home or foreign market, this implies that the returns to selling
at home must also rise. Before foreign firms were selling the good in the home market at FC 10 which converted
into HC 10. With the exchange rate now at S(HC/FC) = 1.1, in order for them to get FC 10 for each sale they must
price at HC 11. This is also the home market price in order to keep local firms from switching to exporting. Thus,
local firms, acting as the import competitors, can also raise their price to 11. Their values rise accordingly to V1 =20,
which also translates into a real increase in firm value.
This is the short run story. The 10% depreciation of the HC leads to a 100% increase in the value of home
country firms that either export or sell locally against foreign competitors. However, the current outcome is not an
equilibrium. In the long run, the higher return to capital in this industry in the home country will draw in additional
resources, bidding up the price of inputs (labor and raw materials) until the return on capital falls to its required
level. This will be the case when the costs of inputs (labor and raw materials) are driven up by 10% to HC 9.9. This
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p. 4
price pressure leads to a one-time bout of inflation that will ultimately result in an aggregate price level increase of
10%, and a home country price index of P2 = 1.10.
When this happens, the home country firm’s cash flows will fall from 2 to 1.1 (HC 11 - HC 9.9) and firm value
will fall to V2 = 11, with the real value of the firm returning to V2/P2 = 11/1.10= 10.
Although the firm’s value is nominally higher than it was originally (11 as compared to 10), this is just adjusting
for the 10% higher prices in the home country. The real value of the firm to investors is the same as before. Many
will notice that the price increase necessary to restore equilibrium is the same increase necessary to re-establish
PPP. The 10% depreciation of the home currency needs to be offset by a 10% increase in home currency prices to
return the real value of the home currency to the initial level. In other words, the real exchange rate change (at time
1), resulted in higher value of home country firms as they temporarily had a competitive advantage over foreign
firms. When the real exchange rate returned to its equilibrium level (time 2), such competitive advantage and the
increase in (real) firm value disappeared.
This dynamic is important to understand because it makes clear why only changes in the real exchange rate
matter. Thus, it should be clear that operating exposure only arises from real exchange-rate changes.
One can also use this example to show that if there were no price frictions in the world, (i.e., the law of one
price held for all goods at all times) this exposure would never arise. In such a world, the depreciation of the HC
would be matched instantaneously by an offsetting rise in all home country prices. As there had never been a real
exchange rate change, the result would be no real change in value. Everything would operate as before but with
higher home country prices and a depreciated HC.
One can work through the dynamics of a 10% real appreciation of the HC and see that in the short run the
profits of the firms with domestic production fall to zero, and return to equilibrium (that level necessary to make the
real value of the firm equal to 10) only when input prices in that sector fall to reduce operating costs sufficiently.
One last important point to note is that the import competitive firms in this example, from outward appearance,
have no direct link to the international markets. They produce their goods with locally priced inputs and sell them in
the local market for home currency. None of their cash flows are denominated in FC; however, these firms still have
an operating exposure to exchange rate changes. Just as with the exporting firms, the value of the import
competitive firms changes as a result of real exchange rate fluctuations. This is because these firms compete against
foreign firms whose costs are based in FC. Therefore, while it is true for translation and transaction exposure, the
simplistic claim that one is not exposed to exchange rate changes because one does not have FC transactions, assets
or liabilities, is not true for operating exposure.
Case of the Importer
While it is tempting to think that the results for a firm involved in importing activities are the opposite of an
exporting firm, this is not always the case. As we will see, it depends crucially on the nature of the market and the
currency in which input prices are determined. For example, suppose that instead of producing in the home market,
a firm owned by home country residents in the above example had its production facilities located in the foreign
country (we would call this firm a multinational). The firm either provides goods to the foreign market (we will
consider the case of foreign operations later) or, acting as an importer, it ships the goods back into the home market.
The key point is that the owners of this firm value their profits in HC.
Consider the case of the firm acting as an importer.
• Originally, as above, the exchange rate is S(HC/FC) = 1 and firm value is V0 = 10.
• Again, there is a 10% real depreciation of the HC, S(HC/FC) = 1.1
• Just as before, the price of the good in the home market rises from HC 10 to HC 11
• The importing firm has costs of FC 9 due to production in the foreign country
• Now the HC needed to cover these costs becomes HC 9.9 (FC 9, $1.1 HC/FC).
This results in a net cash flow of HC 1.1 for the “importing” firm. This is the long run equilibrium profit of the
domestic firms above resulting from the 10% depreciation. So as a result of the depreciation, the value of the
importing firm rises only to V1 = 11 in the short run. There is virtually no change in firm value in the short run
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Corporate Exposure to Exchange Rates
p. 5
(unlike the exporting firms). [In fact, one may argue that there is a relative decrease in firm value compared to
exporting and import competing firms in the same industry in the short run]. Eventually, as the home country’s
general price level rises in response to the increased price pressures resulting from the devaluation, the increase in
prices (10% in the long run) leaves the same real cash flow in HC as before the depreciation for the “importing”
firm. Firm value remains at V2 = 11, but real firm value returns to V2/P2 = 10. In the end, everything is the same
because the change in the real exchange rate has reverted to zero. Working through the case with a 10%
appreciation yields the same result: virtually no change in profitability, and therefore no change in firm value for the
importer. The reason for this much smaller impact of exchange rate changes on the importing firms’ value is that
these firms are “naturally hedged” so that their operating exposures are close to zero. Both the firm’s revenue stream
and cost stream are economically denominated in foreign currency. Only its net cash flows (profits) are exposed to
currency fluctuations. Since this is much smaller than revenues, the exposure is smaller.
This demonstrates a fundamental point about operating exposure analysis: the determination of operating
exposure is really an analysis of the economic currency denomination (as opposed to notational denomination) of the
firm’s cash inflows and outflows.
This example brings out an important point for long run exposure analysis: unexpected real exchange-rate
changes eventually have impacts on overall price levels that offset the original change (i.e. PPP holds in the long
run). A depreciation of the home currency usually puts upward pressure on domestic prices as it raises the costs of
goods with a FC price. There is substantial evidence for this. Inflation in most of the SE Asian countries increased
sharply as a result of those currencies' devaluations. This is a result of two things: one, the depreciation makes all
imported products more expensive immediately, and two, the devaluation also generally stimulates economic activity
(export boom) causing other prices to rise. Conversely, an appreciation of the domestic currency tends to have a
mitigating influence on prices as it makes foreign goods less expensive and depresses domestic activity. This will
cause price-cutting by domestic agents resulting in slower inflation or possibly even deflation. In all the cases
above, prices eventually adjust to restore initial real equilibrium, just at different nominal prices.
Operating Exposure with Imperfect Competition and Strategic Behavior
Despite what economists would like to think, the world is generally not characterized by perfect competition.
Most firms that participate in international activities are large, and tend to have some market power. They also have
the ability to partially segment the markets they serve. However, they do face competition from other international
firms that limits their market power. In a world with imperfect competition, the possibilities for strategic behavior
also arise, in the sense that a firm attempts to gain advantages over its competitors even at some short run cost to
itself. This is presumably because of expected gains from increasing market share (economies of scale) or market
power (driving competitors out of business).
Before we begin, we need to discuss the metric for the strategic pricing behavior. The important question is
how the firm alters the foreign currency price of its good in response to an exchange-rate change. This is known as
the pass-through effect. Pass-through is the ratio of the percentage change in the foreign currency price of your
exports to the percentage change in the foreign currency price of domestic currency.
Pass − through =
% ∆ FC price of export
FC
% ∆ S( HC
)
While pass-through can theoretically take on any value, it is usually in the range between zero and one. These
two points represent specific behaviors with respect to FC price changes and exchange-rate changes. When passthrough is zero, this means that the firm keeps the FC price of the good fixed and therefore, absorbs the gain or loss
(resulting from an exchange rate change) on the HC value of the sale. In cases where pass-through is zero, when the
HC appreciates, the firm sees a decrease in the proceeds of a foreign sale. Similarly, when the HC depreciates and
pass-through is zero, the firm receives the larger HC proceeds of each foreign sale. With pass-through equal to zero,
the firm’s FC price (and therefore quantity sold) remains fixed and the HC revenue per foreign sale fluctuates.
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Corporate Exposure to Exchange Rates
p. 6
When pass-through is one, the firm has “passed through” the entire impact of the exchange-rate change into the
FC price of the good to the foreign consumers. Thus, when the HC appreciates, the firm raises the FC price of the
good by the same proportion as the exchange-rate change, leaving the HC proceeds of a foreign sale the same as
before the exchange rate change. Similarly, when the HC depreciates, the firm lowers the FC price of the good and
receives the same HC proceeds of each foreign sale as before the exchange-rate change. Thus, with pass-through
equal to one, the firm’s FC price (and therefore quantity sold) fluctuates and the HC revenue per foreign sale
remains fixed. Notice that in either case total HC proceeds from the foreign market fluctuate with the exchange rate.
Be aware that price fluctuations in the foreign market will result in quantity fluctuations (as long as demand in
not perfectly inelastic). Another way to think about pass-through is that choosing pass-through of zero attempts to
maintain quantity stability at the expense of HC profit margin stability. Alternatively, choosing pass-through of one
attempt to maintain HC profit margin stability at the expense of quantity stability. In strategic terms, setting passthrough at zero when the HC appreciates and at one when the HC depreciates is an aggressive pricing behavior (one
that seeks to maintain or maximize market share). This is also known as pricing to market. A policy of maintaining
pass-through at one all the time (making the foreign-currency price reflect all the variability in exchange rates)
corresponds to the maintenance of a fixed HC margin on each good. This was a common policy of U.S. firms before
the mid 1980s.
In reality, pass-through can vary anywhere between zero and one, depending on market structure, elasticity of
demand, the behavior of competitors and strategic considerations. In a world where firms have some market power,
the determination of pass-through is a corporate decision that must be made in response to market conditions. As we
shall see below, pass-through decisions do not affect the relative performance of the firms in strategic interaction as
a result of exchange rate changes but they will have an influence on the reported impact of exchange-rate changes on
the reported operating performance.
Let us consider strategic behavior in terms of pricing policy: a firm has market power to choose between the
market-determined trade-off of price and quantity. As such, behavior is more descriptive of the real world, we
consider several examples to demonstrate how operating exposure can vary depending on the activities and strategic
behavior of firms. First, we will examine firms with domestic operations only.
Examples of Operating Exposure with Imperfect Competition
Domestic Production Only
Let us consider a situation where there are two representative firms, one in the U.S. and the other in Germany.
These firms operate in an oligopolistic industry and each possesses some degree of market power. Each firm
produces similar goods that are close substitutes with the others and sells in both countries. There are no transport
costs and the products initially have the same price. Initially, all inputs to production are available in segmented
domestic markets. Assume that under original market conditions the products had the same price and unit
profitability. Also, assume the two firms split each market.
Initially the exchange rate is S($/€) = 1.00. The condition of each firm is:
Cost of production
Price in home market
Price of exports
U.S.
$5
$10
$10 = €10
Germany
€5
€10
€10 = $10
Initially the profit margin is $5 in the U.S. and €5 in Germany. If we assume that each firm sells the same
quantity initially, then the expected value of each firm’s cash flows are the same at the current spot exchange rate.
Suppose the nominal exchange-rate changes unexpectedly resulting in a real exchange-rate change. The new
spot rate is S($/€) = 2.00 ($ depreciation of 50%). There has been no change in input prices. The real dollar
depreciation provides a competitive advantage to the slack to the U.S. exporter. The new situation in the market
depends on the pricing behavior of the firms. The U.S. producer may set pass-through to one by lowering her export
price to €5, squeezing her German competitor, and forcing him to lower his price to €5 or lose market share.
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p. 7
Alternatively, assuming that she has the ability to segment her markets, the U.S. exporter can be passive and keep
her export price at €10 (now $20) and enjoy larger profit margins on the same export quantities as before. In a
similar fashion, the price in the U.S. market will depend on the reaction of the German firm to the exchange rate
change. If the German producer follows pass-through = 1, then the price of German imports in the US rises to $20
(€10 @ $2/€), leaving the US producer room either to raise her domestic price and/or increase her share of sales in
the US market.
The possible polar cases resulting from the 50% dollar depreciation (S($/€) = 2), look like:
German firm
PT = 1
PT = 0
U.S. Firm
PT = 0
Costs
PHOME
PEXPORT
PROFIT
PT = 1
Costs
PHOME
PEXPORT
PROFIT
U.S.
$5
$20
$20 = €10
Germany
€5
€10
€10 = $20
HOME = $15
EXPORT = $15
HOME = €5
EXPORT = €5
U.S.
$5
$20
$10 = €5
Germany
€5
€5
€10 = $20
HOME = $15
EXPORT = $5
HOME = €0
EXPORT = €5
1
3
U.S.
$5
$10
$20 = €10
Germany
€5
€10
€5 = $10
HOME = $5
EXPORT = $15
HOME = €5
EXPORT = €0
U.S.
$5
$10
$10 = €5
Germany
€5
€5
€5 = $10
HOME = $5
EXPORT = $5
HOME = €0
EXPORT = €0
2
4
In addition to these four polar cases, there is an infinite set of possible results in between.
In all four cases, the U.S. producer has gained relative to the German producer. In square 1, both the U.S. and
German producers react passively to the exchange rate change. The result is a price increase in the U.S. by both
producers. However, this price increase only leads to higher profit margins for the U.S. firm [note that there will be
a decrease in the quantity demanded as a result of the price increase, but this will be shared by both firms]. Unless
the decrease in quantity demanded is substantial, the U.S. firm should benefit because in has tripled its profit margin
on domestic sales while the German firm’s profit margin on exports remains unchanged (because of the change in
the exchange rate). In the German market, since the U.S. firm reacted passively, the price remains at €10. Thus the
German firm see no change in its cash flows from the domestic market; however, the U.S. firm, by selling at €10
now receives $20 for each sale, resulting in much higher dollar cash flows from the German market. The German
firm experiences only a partial decrease in total cash flows (due to the decreased sales in the U.S.) resulting from the
price rise, while the U.S. firm experiences an increase in cash flows, from exports, and perhaps, also from domestic
sales (depending on demand elasticity). Thus, the U.S. firm has improved its competitive position vis-a-vis its
German competitor.
In square 4, the same relative result holds, except it takes a dramatically different form. As both firms have
priced aggressively, the consumer is the big winner. The price in the U.S. market remains at $10 and the price in the
German market is driven to €5 by the aggressive U.S. pricing. As a result, the German firm is severely squeezed. It
earns no profits on its export sales in the U.S. as the $10 just covers the €5 costs. It also makes no profits in the
German market with the price driven down to €5. On the other hand, the U.S. firm’s cash flows increase but only
slightly. In the U.S. market, nothing has changed for the U.S. firm: it still sells the same quantity at $10 per sale. In
the German market, by pricing at €5 the U.S. firm will experience an increase in export sales [just as the German
firm will experience an increase in domestic sales due to the price reduction], and the dollar profit margin on each
export sale is the same as it was prior to the exchange rate change. Thus in square 4, the U.S. firm experiences a
small increase in cash flows—from the export market—while the German firm is severely squeezed, experiencing a
dramatic decrease in cash flows and perhaps facing financial distress.
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It is important to note that the off-diagonal entries (squares 2 and 3) require the ability to segment markets as the
price of the good is significantly different in one country than the other. Unless market segmentation exists,
arbitrageurs will purchase the item in the low cost area and ship them to the high cost location arbitraging away the
price difference. In the absence of this ability, the results will lie somewhere in between with the prices possibly
converging around some level like $15 and €7.5. In any case, it can be seen by examining these situations that the
U.S. firm experiences a relative increase in its cash flows compared to the German firm.
The bottom line is that a depreciation of the domestic currency benefits the competitive position (cash flows and
thus value) of domestic firms involved in exporting or import competing activity. This benefit continues until the
real exchange rate returns to its original level.
U.S. Firm with Imported Inputs to Production:
Suppose that the U.S. firm changed the sourcing of its inputs to make use of some inputs that are sold in
Canada. In addition, let us assume that the U.S. firm does not export, but does face competition from the German
exports. The imported inputs used by the U.S. firm come from Canada and their price is determined in the Canadian
market in Canadian dollars. Let us assume that initially S(C$/$) = 1.00. Together with all of the original
assumptions from above, we have the following situation with the German competitor (assume it does not use
imported inputs):
Cost of local input
Cost of imported input
Total Cost
Price in U.S. market
U.S.
$2
C$3 = $3
$5
$10
Germany
€5
€5
€10 = $10
The initial profit margins are $5 per unit for the U.S. local market sales and €5 per unit on each German export
to the U.S.
Now suppose that there is a real change in the value of the Canadian dollar, so that S(C$/$) = 1.5 (dollar
appreciation against the Canadian dollar), while prices in Canada remain the same [the price of the input the U.S.
firm imports from Canada remains at C$3]. If the exchange-rate change is due to Canadian factors so that S($/€)
remains unchanged at $1/€ the following are the polar cases assuming fixed Canadian prices:
Aggressive Pricing Behavior
U.S. firm
local input costs
imp input costs
Total costs
PUS
PROFIT IN US
U.S.
$2
C$3=$2
$4
$9
$5
Germany
€5
€5
€9=$9
€4
1
Passive Pricing Behavior
U.S.
$2
C$3=$2
$4
$10
$6
Germany
€5
€5
€10=$10
€5
2
Although these represent just two of many possible market outcomes because of these events, it draws out two
important points. First, as an importer of inputs to goods that are sold in a competitive foreign market, the U.S. firm
gains a competitive advantage as a result of the appreciation of its home currency against that foreign currency (the
Canadian dollar) vis-a-vis the German competitor. The C$/$ exchange-rate change reduces the dollar costs of its
imported inputs and thereby reduces its costs of production.
In square 1, we assume the U.S. firm takes an aggressive pricing behavior and lowers its final output price by
the full amount of the imported input price reduction. [Note: while this is analogous to PT = 1, it is not exactly the
same as our definition because the firm is changing a domestic currency price]. The result of the domestic price
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Corporate Exposure to Exchange Rates
p. 9
reduction is that it forces the German firm to react, either by lowering its export price or surrendering market share.
The net result of the lower price is more domestic sales with the same profit margin per sale, leading to greater cash
flows for the U.S. firm, and a decrease in export cash flows for the German firm.
In square 2, a similar result will hold, but as with the previous table, it will take a slightly different form. In this
situation, we assume that the U.S. firm takes a passive pricing stance (the analogous position to PT = 0) and keeps
the benefits of the reduced input costs in the form of a higher profit margin. Thus, the price in the U.S. market does
not change, so quantity demanded does not change, but the U.S. firm now has a profit margin of $6 on each sale
whereas it had only $5 before. This leads to greater cash flows for the U.S. firm. The German firm on the other
hand, sees no change in the market. The price is still $10, which converts into receipts of €10 on each export sale.
Also, as quantity demanded does not change its cash flows from exporting do not change. However, the German
firm is now facing a stronger competitor in the U.S. market. This may lead to some second-order valuation effects
that could slightly reduce the value of the German firm. However, the relative result is the same, a relative increase
in cash flows and value for the U.S. firm.
This example demonstrates the simple intuition regarding the operating exposure of importing firms: firms that
import goods with fixed foreign currency prices gain from a real appreciation of their home currency. Note that this
is different from the exposure of an importing firm in a perfectly competitive environment.
A similar situation would hold in our example above if the Canadian firm exporting the good to the U.S.
producer increased his C$ price (kept the $ cost the same) in response to the exchange rate change (i.e. set his passthrough = 0). However, everything else held constant, importing creates a positive relation between the change in
expected cash flows and the change in the real value of the home currency.
The second point to note from this example is that the result of the Canadian dollar’s real depreciation against
the U.S. dollar also implies a real depreciation of the Canadian dollar against the Euro.
From triangular arbitrage, S(C$/€) was originally 1.00 and has now become S(C$/€) = 1.50.
Although the German firm does not interact in the Canadian market, its cash flows can be affected by the real
depreciation of the Canadian dollar. In square 1, due to the decrease in the U.S. market price, the German firm must
lower its export price or lose sales. Thus, the current and expected future cash flows of the German firm from
exporting to the U.S. market will have fallen, and with it, firm value. This demonstrates the point that you need not
transact in a currency in order to have an operating exposure to it. If your competitors’ costs are exposed to a
particular foreign currency, then you also will have some exposure to that foreign currency.
Real Exchange Rate Exposures Even with No Exchange-Rate Change
While changes in nominal exchange rates are the most common source of real exchange rate fluctuations—
resulting in a high correlation between nominal and real exchange-rate changes—real exchange rates may also
change due to relative price changes even when nominal exchange rates are constant. This is especially true in
developing countries and Europe where there are attempts to maintain fixed nominal exchange rates. Real exchange
rate changes of this sort also give rise to operating exposures that can affect firm cash flows and thus current market
value. Although they occur due to price changes (rather than FX changes), they usually occur more slowly. As a
demonstration of this phenomenon, let us take the U.S. firm from the previous example and consider the effect of a
generalized price increase in Canada relative to the U.S. with no offsetting change in the value of the Canadian
dollar.
Originally the cost of the imported Canadian input was C$3 = US$3 resulting in a total cost per good for the
U.S. firm of $5. Now assume prices in Canada rise by 33% relative to the U.S. (Canada has 33% higher inflation
than the U.S.) while the exchange rate remains fixed at S(C$/$) = 1.0. The result of this event is a real appreciation
of the Canadian dollar and the price of the Canadian input rising from C$3 to C$4 leading to production costs of the
U.S. firm rising from $3 to $4. Now the total cost per good for the U.S. firm rises to $6. This squeezes the cash
flows of the U.S. firm competing with the German firm in the U.S. market. (it either squeezes its profit margin to $4
or loses market share be raising price to $11. The result is exactly analogous to a real appreciation of the Canadian
dollar due to a nominal exchange rate movement with fixed input prices; however, this time the exchange rate stayed
fixed and prices moved. This is also different from domestic inflation under which both input and output prices
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Corporate Exposure to Exchange Rates
p. 10
would have risen. This distinction is important to keep in mind when we discuss hedging operating exposure
because this type of operating exposure to real exchange-rate changes cannot be hedged via nominal foreign
currency contracts.
Summary of Impact of Exchange-Rate Changes on Firm’s Local Production Cash Flows
Real Depreciation of the Home Currency :
• increases profitability of exporters through higher margins and/or increased sales
• decreases profitability of importers through lower margins and/or decreases sales
• increases profitability of import competitors through higher margins and/or sales
Real Appreciation of the Home Currency:
• decreases profitability of exporters through lower margins and/or decreased sales
• increases profitability of importers through higher margins and/or increase sales
• decreases profitability of import competitors through lower margins and/or sales
Operating Exposure and Foreign Operations
We have considered the operating exposures to different activities when production was carried out in the local
market. For multinational firms, on the other hand, a substantial amount of production occurs in foreign markets,
generally with foreign currency costs. This production may be sold in the local market, exported to some other
foreign market where it is sold for another foreign currency, or it may be sold back to the parent’s domestic market.
Under these scenarios, exposures can differ substantially in terms of the value of the operating flows back to the
parent operating flow. Generally speaking, there are two things going on when determining the exchange rate
exposure of foreign operation cash flows from the parent’s point of view. First, there is the exposure of the
operating cash flows denominated in the foreign currency (analogous to what we examined above). Second, there is
a valuation (or conversion) effect resulting from measuring the net foreign currency cash flows in the parent’s
currency. The size and sign of these two effects determine the operating exposure to the parent foreign operations.
Below we consider several examples to demonstrate the possible outcomes. These examples are simple,
ignoring the impacts of transaction exposures to focus completely on the operating exposure of foreign subsidiaries.
No Operating Exposure in Foreign Currency
Consider the case of a stand-alone German subsidiary of a U.S. parent. Let us assume that this firm produces in
Germany with € costs and sells its goods in the German market. The initial exchange rate is S($/€) = 1.00 and a
provisional estimate of expected cash flows generated by the subsidiary for the coming period looks as follows:
German Subsidiary of U.S. Parent
Revenues
Cost of goods
Profit
€100
€90
€10
At the current exchange rate, the contribution of the foreign subsidiary to the parent’s consolidated financial
performance is $10 (€10 x $1/€).
Now suppose that the S($/€) exchange rate changes to S($/€) = 0.50 (50% euro depreciation) with no immediate
change in prices in either country. Since the disturbance causing the exchange-rate change was common to all
exchange rates with the dollar, cross rates of other currencies against the € that may influence the firm remain the
same. To a first approximation, the exchange-rate change has no impact on the € cash flows generated by the
____________________________________________________________________________________
Corporate Exposure to Exchange Rates
p. 11
German subsidiary: they remain at €10. Although it has no impact on the € cash flows of the German subsidiary, the
exchange-rate change has a one-for-one change on the dollar value of these cash flows: they fall to $5 (€10 / $0.5/€).
Thus the dollar appreciation reduces the dollar value of the expected future cash flows of the foreign subsidiary to
the U.S. parent, via the conversion effect—by the amount the dollar changed in value against the €. Note that this
exchange rate impact on subsidiary value is the same as the effect on a fixed € payoff instrument such as a bank
deposit or a government bond.
This demonstrates that when the foreign currency cash flows are independent of the exchange-rate change,
either because of a lack of exposure to that particular exchange-rate change or a complete lack of exposure to
exchange-rate changes (i.e., barbershops), there is a negative relation between a change in the real value of the
parent currency vis-a vis the subsidiary currency and the parent-currency value of the foreign subsidiary. Note, for
simplicity we are ignoring an accounting adjustment that may occur because of translation or transaction hedging.
However, it is difficult to conceive of a firm that does not have some exposure to exchange rates. Under more
realistic assumptions, the impact of exchange rate changes on the parent’s currency value of foreign operations
requires a more careful look. As we shall see, it depends on identifying the size and the sign of the foreign
subsidiary’s operating exposure.
Subsidiary with Operating Exposure on the Cost Side
Consider a German subsidiary of a U.S. parent with cost exposure. For example, let us assume that the German
firm is a manufacturer that imports certain inputs to the production process from abroad (a foreign country that uses
the foreign currency FC). Since the German subsidiary is an importer, we know it has an operating exposure on the
cost side. To keep the analysis simple, we shall continue to assume that this subsidiary only sells its good in the
German market and has no operating exposure in its revenues.
The initial exchange rates are S($/€) = 0.50 and S(FC/€) = 3.00. A provisional estimate of expected cash flows
generated by the subsidiary in the near future looks as follows:
German Subsidiary of U.S. Parent
Revenues
Local input costs:
Imports FF120 @3FC/€:
Total Costs
Profit
€100
€40
€40
€80
€20 = $10 from parent perspective
At the current $/€ exchange rate, this subsidiary is expected to contribute $10 per period to the parents overall
expected cash flows.
Consider the exposure to the parent from this subsidiary enterprise of a generalized real appreciation of the €
(real depreciation of dollar against €). This appreciation of the € raises the exchange rates to S($/€) = 1.00, and
S(FC/€) = 6.00. Given the assumed market conditions, revenue exposure is second order and is ignored; however,
there is a cost exposure due to the importation of some inputs to production that are priced in foreign currency. As a
result of the exchange-rate change, the expectation of Euro cash flows for the subsidiary become:
German Subsidiary of U.S. Parent
Revenues
Local input costs:
Imports FF120 @6FC/€:
Total Costs
Profit
€100
€40
€20
€60
€40 = $40
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Corporate Exposure to Exchange Rates
p. 12
Now the German subsidiary’s expected € cash flows rise to €40 which convert into $40 from the parent’s
perspective. With the subsidiary’s cost exposure, the exposure of the parent arising from the foreign subsidiary was
negatively related to the change in the real value of the parent currency and larger than in the case when the
subsidiary had no operating exposure. Here the operating exposure of the subsidiary and the valuation effect are
both working in the same direction. The operating exposure is the change in expected € cash flows from €20 to €40.
The valuation effect is the result of every € now being worth $1 instead of $0.50.
Operating Exposure on the Revenue Side
The opposite situation emerges when the foreign subsidiary has an operating exposure on the revenue side.
Consider a German subsidiary with a revenue exposure. For example, assume that the German subsidiary is a
manufacturing plant that competes with non-EU firms in selling its good in Germany as well as the other non-EU
countries (that use the foreign currency FC). As this subsidiary is an exporter, we know it has a revenue exposure.
For simplicity, we shall assume that there is no cost exposure: all production costs are denominated and determined
in €. Let us consider the same original exchange rates as the previous example, S($/€) = 0.50 and S(FC/€) = 3.00.
A provisional expectation of the € cash flows to the German subsidiary are:
German Subsidiary of U.S. Parent
Local € revenues:
Export rev FF 90 @ 3FC/€:
Total revenues
Total Costs
Profit
€70
€30
€100
€80
€20 = $10
At the current $/€ exchange rate, this subsidiary is expected to contribute $10 per period to the parents overall
expected cash flows.
As before, consider the exposure to the parent from this enterprise of a generalized real appreciation of the €.
This appreciation of the € changes the exchange rates to S($/€) = 1.00, and S(FC/€) = 6.00. Given our assumptions,
cost exposure should be considered second order and is ignored; however, there is a revenue exposure due to the
export of some outputs priced in francs. As a result of the exchange-rate change, the expectation of € cash flows for
the subsidiary become:
German Subsidiary of U.S. Parent
Local € revenues:
Export rev FF90@6FC/€:
Total revenues
Total Costs
Profit
€70
€15
€85
€80
€5 = $5
In this case, the parent sees a drop in the expected dollar cash flows from the German subsidiary resulting from
the real appreciation of the € (depreciation of the dollar). This is despite the fact that now each € is converted into
$1 at the current exchange rate. This negative exposure arises because the decrease in net € cash flows (profits) as a
result of the currency movement [from €20 to €5, (-75%)] is more dominant than the change in the € value of the
dollar [from €2/$ to €1/$ (-50%)]. Put another way, these two effects, the operating exposure of the subsidiary and
the valuation effect to the parent were working in opposite directions. In this example, it happened that underlying
cash flows fell by more than the valuation effect could counteract, causing the net dollar cash flows to fall.
In certain cases, it is possible to have a foreign subsidiary that is “operationally” hedged. This occurs when the
size of these two impacts of exchange rate changes on the parent’s valuation of a foreign subsidiary exactly offset.
Such would be the situation in the following example:
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Corporate Exposure to Exchange Rates
p. 13
German Subsidiary of U.S. Parent
Local € revenues:
Export rev FF 60 @ 3FC/€:
Total revenues
Total Costs
Profit (exchange rate at 2€/$)
€80
€20
€100
€80
€20 = $10
At the current $/€ exchange rate of 0.50, this subsidiary is expected to contribute $10 per period to the parents
overall expected cash flows.
Once again, assume a generalized real appreciation of the €. This appreciation of the € changes the exchange
rates to S($/€) = 1.00, and S(FC/€) = 6.00. As a result of the exchange-rate change, the expectation of € cash flows
for the subsidiary become:
German Subsidiary of U.S. Parent
Local € revenues:
Export rev FF60 @6FF/€:
Total revenues
Total Costs
Profit
€80
€10
€90
€80
€10 = $10
In this situation, the exposure to the parent firm is zero. The change in the exchange rate has had no impact on
the expected cash flows from foreign operations. The operating exposure and the conversion effect exactly offset.
Note that this is a rare situation, but does drive home why some multinational firms operations may have relatively
low exposures.
A third possibility with the revenue exposure is that if the revenue exposure is small enough (goes to zero) we
move toward the initial case of a firm without operating exposure (examined above). In this case, the parent
benefited from the dollar depreciation against the €. Thus, for foreign operations with revenue exposures, the
exposure to the parent depends on the size of the revenue exposure. If the revenue exposure is small with respect to
the cost exposure, the parent benefits from a home currency depreciation. As the revenue exposure gets large, the
parent gain from a depreciation of its home currency gets smaller and at some point, the firm is naturally hedged. As
the net revenue exposure continues to increase, we move to a situation where the parent actually is financially
harmed by a home currency depreciation against the subsidiary currency. Thus, the operating exposure of a parent
with a foreign subsidiary with a net revenue exposure is ambiguous. It depends on the relative sizes of the operating
and conversion exposures.
A final word of warning, in these examples regarding foreign operations we have considered price effects as the
source of operating exposure. While this may be valid for cost exposures, it is clearly not valid for revenue
exposures as the change in competitiveness may change the quantity of items sold as well as the subsidiary’s
currency price of the items. This, as we shall see, is what makes estimating exposures a difficult task.
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Corporate Exposure to Exchange Rates
p. 14
Example of Cournot Duopoly: Noncooperative Nash equilibrium in quantities
Below we consider a general equilibrium example of a foreign operation’s exposure based upon a simple
Cournot competition model. This will allow us to work out the effects mathematically and see the interaction of the
operating exposure and conversion effect for a foreign operation of a US firm competing with another foreign firm.
This way we can determine with respect to a common competitive situation the relative importance of these two
offsetting exposure effects on the total exposure to the parent.
Consider a simple setup: 2 Firms •
Firm 1: A U.K subsidiary of a US parent that produces in Britain with pound costs and sells a product both
in its home market and also exports to Germany.
• Firm 2: A German firm that produces a highly substitutable product in Germany with DM costs and
competes against the U.K. subsidiary in both the German market and the British market.
Assuming no market segmentation, the demand curve facing the two firms is:
PDM = 75 - 2Q
where Q = q1 + q2, and without loss of generality, the demand curve price is arbitrarily denominated in DM.
The British firm has a cost of production of £c1 , and the German firm has a cost of production of DMc2 .
The profits of Firm 1 in pounds are given by:
£
) • P • q1 − c1 • q1
π 1£ = S( DM
but the profits in US dollar terms to the U.S. parent are given by:
£
) • P • q1 − c1 • q1 ]
π 1$ = S( £$ )[ π 1£ ] = S( £$ )[S( DM
The profits of Firm 2 in € are given by:
π 2DM = P • q2 − c2 • q2
The firms simultaneously maximize profit by choosing the quantity of output to produce:
∂P( q1 ,q2 )
∂ π 1£
£
= S( DM
)[
• q1 + P] − c1 = 0
∂ q1
∂ q1
∂ π 2DM ∂P( q1 ,q2 )
=
• q2 + P − c2 = 0
∂ q2
∂ q2
Given the functional form for P, we can substitute to obtain the following two equations in two unknowns, q1
and q2. Solving these two equations simultaneously produces profit-maximizing choices for each firm
conditional on the choice of the other firm.
We can now simulate the impact of currency fluctuations on the profits of the two firms. Rather than make
explicit assumptions about rates and case, we shall assume that our base case is such that PPP holds and the
costs of production are equal, S(£/DM)c2 = c1. From this baseline, we shall consider the relative impact of
various exchange rate changes on firm profitability.
The following chart displays the impact on $ profits to Firm 1, relative to the baseline case, for a ±10% change
in the relevant exchange rates. Keep in mind that Firm 1 profits are denominated in dollars, and as such are
sensitive to changes in both S(£/$) and S(£/DM) via an operating exposure (pile effect) and a conversion effect.
____________________________________________________________________________________
Corporate Exposure to Exchange Rates
p. 15
The results of the simulation are rather intuitive. When the S($/£) rises and the S(£/DM) rate stays fixed, the
dollar profits to Firm 1 increase from the pure conversion effect. [This is moving diagonally from the front right
to the back left]. Similarly, when the S($/£) stays fixed and the S(£/DM) falls, then dollar profits rise from the
operating exposure effect. [This is moving backward in each S($/£) row]. It is apparent that the operating
exposure effect is much larger than the conversion effect. Thus, this U.S. parent has more of a € exposure than
a £ exposure from its subsidiary. To the extent that the £ and the DM move together against the $, this U.S. firm
has a limited overall economic exposure. The U.S. parent should be most concerned about the possibility of a
simultaneous DM weakening and £ strengthening against the $ as this would have the largest negative impact on
UK Subsidiary Profits in $
S(Stg/DM) on each bar
1.60
1.22
1.40
1.1
1.20
1.11
1
1.00
1
1
0.91
0.80
0.60
0.9
0.81
0.40
0.20
S($/ D M)
1.10
0.00
1.00
0.90
1.10
1.00
0.90
S($/ Stg)
profits.
Important Extensions on Operating Exposure
While we have gone through several examples of operating exposure, it is important to note a few extensions to
the analysis that were not always explicitly mentioned or were ignored in the cases above. The primary caveat
is to keep in mind that the impact of large changes in the exchange rate is not necessarily just a linear multiple
of a small exchange rate change. While people sometimes respond only passively to small changes, they may
react quite dramatically to large changes in their environment. Examples of different groups’ possible reactions
to large exchange rate changes include:
Consumers: As we have shown, large changes in the real exchange rate result in substantial changes in relative
prices and as such, they influence the relative purchasing power of a consumer’s currency. When the dollar
appreciates substantially, as it did in the early 1980s, this leads to an increase in the purchasing power of the
U.S. dollar. Not only will this lead to a relative increase in the purchase of foreign goods, but through an
income effect of the increased purchasing power of U.S. residents, it may also lead to an increase in both foreign
and domestic purchases. Such an effect may mitigate the negative influence of a large appreciation on a U.S.
exporter that also has sales in the U.S. This potential impact of large exchange rate changes was not considered
in the examples above.
Public Sector: It should be no surprise that politicians and governments may also react to large real exchange
rate changes. Large changes in real exchange rates cause governments to consider protectionist policies, offer
tax breaks for new (possible foreign ) investment, or place controls on capital and exchange flows. These
policies can have impacts on the value of either the domestic or the foreign firm that were not considered above.
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Corporate Exposure to Exchange Rates
p. 16