Finance 4328 (Moore)
Chapter 11 Notes
Summer 2006
Measuring and Managing Economic Exposure
Chapter 11
PART I. FOREIGN EXCHANGE RISK AND ECONOMIC
EXPOSURE
I.
FOREIGN EXCHANGE RISK
A. Economic exposure focuses on the impact of currency
fluctuations on firm’s value.
1. The most important aspect of foreign exchange risk
management:
Incorporate expectations about the risk into all basic
decisions of the firm.
2. Definition: Economic exposure =
Transaction exposure + Operating exposure:
arises because currency fluctuations alter a company’s
future revenues and expenses.
To measure operating exposure requires a longer-term
perspective.
i.e. Cost and price competitiveness could be affected by
exchange rate changes
Operating Exposure begins:
The moment a firm starts to invest in a market subject to foreign
competition or in sourcing goods or inputs abroad.
The new investment includes:






New product development
A distribution network
Brand name development
Marketing
Foreign supply contracts
Production facilities
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Finance 4328 (Moore)
Chapter 11 Notes
Summer 2006
B. Real Exchange Rates Changes and Risk
Nominal v. real exchange rates:
real rate has been adjusted for price changes.
C. Implications
1. If nominal rates change with an equal price change, no
alteration to cash flows.
2. If real rates change, it causes relative price changes and
changes in purchasing power.
A decline in the real value of a currency:
Makes exports and import-competing goods more competitive.
An appreciating currency makes:
Imports and export-competing goods more competitive.
During an appreciation of home currencies:
Exporters face two choices:
- Keep prices constant (but lose sales) or adjust prices to
foreign currency to maintain market share (lose profits).
3. SUMMARY
a. The economic impact of a currency change depends on the
offset by the difference in inflation rates or the change in real
exchange rates.
b. It is the relative price changes that ultimately determine a
firm’s long-run exposure.
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Finance 4328 (Moore)
Chapter 11 Notes
Summer 2006
PART II. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE
CHANGES
I.
ECONOMIC CONSEQUENCES
The impact on Operating Exposure of a real rate change depends
upon:
Pricing flexibility and
1. Price elasticity of demand
2. Degree of product differentiation
3. The Ability to shift production and the substitution of inputs
If HC Appreciates
Pricing Flexibility is key
Can the firm maintain its profit margins both at home and abroad?
If price elasticity of demand is low, the more price flexibility a firm
has.
i.e. Availability of good substitutes
Product Differentiation
Price elasticity depends on degree of differentiation.
The greater the differentiation, the more the firm can control its
prices.
e.g. Mercedes Benz cars
The Ability to Shift Production and to source inputs from
other countries
e.g. Japanese car makers in the late
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1980’s
Finance 4328 (Moore)
Chapter 11 Notes
Summer 2006
PART III.MANAGING OPERATING EXPOSURE
I. INTRODUCTION
Operating exposure management requires long-term operating
adjustments and the involvement of all departments.
II. Marketing Strategy
A. Market Selection:
Use competitive advantage to carve out market share when
currency values change.
B. Pricing strategy: Expectations critical
1.
If HC depreciates, exporter gains competitive advantage by
increasing unit profitability or market share.
2.
The higher price elasticity of demand, the more currency risk
the firm faces by other product substitution.
C. Product Strategy
Exchange rate changes may alter:
1. The timing of new product introductions
2. Product deletion
3. Product innovations
III. Product Management Adjustments
A. Input mix “shop the world”
B. Shift production among plants
C. Plant relocation
D. Raising productivity
IV. Planning For Exchange-Rate Changes
A. Develop contingency plans with plausible scenarios
before the impact of a currency change makes itself felt.
e.g. Flexible manufacturing systems
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Finance 4328 (Moore)
V.
Chapter 11 Notes
Summer 2006
Financial Management of Exchange Rate Risk:
Financial manager’s Role
 Structure the firm’s liabilities in such a way that the
reduction in asset earnings is matched by corresponding
decrease in cost of servicing liabilities.
A.
Provide the local manager with forecasts of inflation and
exchange-rate changes.
B.
Identify and focus on competitive
C.
Design the evaluation criteria so that operating managers
neither rewarded or penalized for unexpected exchange-rate
changes.
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exposure.