Chapter 12 Management of Economic Exposure Management 3460

advertisement
Management 3460
Institutions and Practices in
International Finance
Fall 2003
Greg Flanagan
Chapter 12
Management of
Economic Exposure
Chapter Objectives
The student will be able to:
list and explain three types of exchange risk
exposure.
calculate a measure of economic exposure.
discuss the determinants of operating exposure.
explain pass-trough pricing and what determines
its effectiveness.
explain the methods for managing economic
exposure.
Discuss alternative methods of hedging economic
exposure.
2
November 18, 2003
Three Types of Exposure
Economic Exposure – the extent to which the value
of the firm would be affected by unanticipated
changes in exchange rates.
Transaction Exposure – the sensitivity of “realized”
domestic currency values of the firm’s contractual
cash flows denominated in foreign currencies to
unexpected exchange rate changes. (Chapter 13)
Translation Exposure – the potential that the firm’s
consolidated financial statements can be affected by
changes in exchange rates. (Chapter 14)
3
November 18, 2003
Economic Exposure
Exchange rate risk as applied to the firm’s
competitive position.
Any anticipated changes in the exchange
rates would have been already discounted
and reflected in the firm’s value.
Economic exposure can be defined as the
extent to which the value of the firm would
be affected by unanticipated changes in
exchange rates.
4
November 18, 2003
Transaction Exposure
Defined as the sensitivity of “realized”
home currency values of the firm’s
contractual cash flows denominated in
foreign currencies to unexpected exchange
rate changes.
Transaction exposure arises from fixed-price
contracting in a world of constantly
changing exchange rates.
5
November 18, 2003
Translation Exposure
Exchange rate risk as applied to the firm’s
consolidated financial statements.
Consolidation involves translation of
subsidiaries’ financial statements from local
currencies to home currency.
Involves many controversial issues.
6
November 18, 2003
How to Measure
Economic Exposure
Economic exposure is the sensitivity of the
future home currency value of the firm’s assets
and liabilities and the firm’s operating cash flow
to random changes in exchange rates.
There exist statistical measurements of
sensitivity.
Sensitivity of the future home currency values of
the firm’s assets and liabilities to random changes
in exchange rates.
Sensitivity of the firm’s operating cash flows to
random changes in exchange rates.
7
November 18, 2003
Channels of Economic
Exposure
Asset exposure
Home currency
value of assets and
liabilities
Exchange
rate
fluctuations
Operating exposure
8
Firm
Value
Future operating
cash flows
November 18, 2003
How to Measure
Economic Exposure
a regression on the (home) dollar value (P)
of foreign assets on the dollar exchange rate,
i.e. S($/£), the regression would be of the
form:
P = a + b×S + e
Where:
a is the regression constant
e is the random error term with mean zero.
b is the regression coefficient and measures the sensitivity of
the dollar value of the assets (P) to the exchange rate, S.
9
November 18, 2003
How to Measure
Economic 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.
10
November 18, 2003
How to Measure
Economic Exposure
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=
11
Cov(P,S)
Var(S)
November 18, 2003
Example
Suppose a U.S. firm has an asset in Britain
whose local currency price is random.
For simplicity, suppose there are only three
states of the world and each state is equally
likely to occur.
The future local currency price of this British
asset (P*) as well as the future exchange rate
(S) will be determined, depending on the
realized state of the world.
12
November 18, 2003
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
13
November 18, 2003
Example (continued)
State
Probability
P*
S
S×P*
Case 1
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
In case 1, the local currency price of the asset
and the exchange rate are positively correlated.
This gives rise to substantial exchange rate risk.
14
November 18, 2003
Example (continued)
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
In case 2 the local currency price of the asset and
the exchange rate are negatively correlated.
This offsets the exchange rate risk substantially.
(Completely in this example.)
15
November 18, 2003
Example (continued)
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
In case three, the local currency price of the asset
is fixed at £1,000
This “contractual” exposure can be completely
hedged.
16
November 18, 2003
Operating Exposure: Definition
The effect of random changes in exchange
rates on the firm’s competitive position,
which is not readily measurable.
A good definition of operating exposure is
the extent to which the firm’s operating cash
flows are affected by the exchange rate.
17
November 18, 2003
Operating Exposure
Note that operating exposure has two
components:
The Competitive Effect—changes in the
exchange rate affect the competitive position of
the firm in the market.
Conversion effect—operating cash flow in home
currency falls with a currency depreciation.
18
November 18, 2003
Determinants of Operating
Exposure
The operating exposure cannot be readily
determined from the firm’s accounting statements
as can transaction exposure.
The firm’s operating exposure is determined by:
The market structure of inputs and products:
how competitive or how monopolistic the
markets facing the firm are.
The firm’s ability to adjust its markets, product
mix, and sourcing in response to exchange rate
changes.
19
November 18, 2003
Determinants of Operating
Exposure
A firm is subject to high degrees of operating
exposure when either its cost or price is
sensitive to exchange rate changes.
On the other hand, when both the cost and
price are sensitive or insensitive to exchange
rate changes, the firm has no major operating
exposure.
20
November 18, 2003
Determinants of Operating
Exposure
The extent to which a firm is subject to
operating exposure depends on the firm’s ability
to stabilize cash flows in the face of exchange
rate changes.
Facing exchange rate changes a firm may
choose one of the following three pricing
strategies:
pass the cost shock fully to its selling prices
(complete pass-through) a inelastic demand
fully absorb the shock to keep its selling prices
unaltered ( no pass-through) a elastic demand
do some combination of the two strategies
described above (partial pass-through).
21
November 18, 2003
Managing Operating Exposure
Selecting Low Cost Production Sites
Flexible Sourcing Policy
Diversification of the Market
R&D and Product Differentiation
Financial Hedging
22
November 18, 2003
Selecting Low Cost
Production Sites
A firm may wish to diversify the location of
their production sites to mitigate the effect of
exchange rate movements.
i.e. Honda built North American factories in
response to a strong yen, but later found itself
importing more cars from Japan due to a weak
yen.
May prevent economies of scale and scope.
23
November 18, 2003
Flexible Sourcing Policy
Sourcing—produce where input costs are low or
buy parts where produced the cheapest.
Doesn’t only apply to components, but also to
“guest workers”.
i.e. 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.
24
November 18, 2003
Diversification of the Market
Selling in multiple markets to take
advantage of economies of scale and
diversification of exchange rate risk.
Diversifying across business lines—
conglomerate.
May create inefficiency and losses.
25
November 18, 2003
R&D and Product
Differentiation
Successful R&D that allows for
cost cutting
enhanced productivity
product differentiation.
Successful product differentiation gives the
firm less elastic demand—which may
translate into less exchange rate risk.
26
November 18, 2003
Financial Hedging
The goal is to stabilize the firm’s cash flows
in the near term.
Financial Hedging is distinct from operational
hedging.
Financial Hedging involves use of derivative
securities such as currency swaps, futures,
forwards, currency options, among others.
See Merck case.
27
November 18, 2003
Download