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.
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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)
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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.
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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.
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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.
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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.
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Channels of Economic
Exposure
Asset exposure
Home currency
value of assets and
liabilities
Exchange
rate
fluctuations
Operating exposure
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Firm
Value
Future operating
cash flows
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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.
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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.
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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=
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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.
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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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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.
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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.)
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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.
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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.
A good definition of operating exposure is
the extent to which the firm’s operating cash
flows are affected by the exchange rate.
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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.
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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.
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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.
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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).
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Managing Operating Exposure
Selecting Low Cost Production Sites
Flexible Sourcing Policy
Diversification of the Market
R&D and Product Differentiation
Financial Hedging
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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.
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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.
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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.
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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.
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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.
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