hedging economic exposure
DESCRIPTION
Hedging Economic Exposure. Transaction Exposure vs. Economic Exposure. Profits = e (Price – Unit Costs) Q. Economic exposure refers to changes in the $ value of costs/revenues due to changes in demand (caused by exchange rate movements). - PowerPoint PPT PresentationTRANSCRIPT
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Hedging Economic Exposure
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Transaction Exposure vs. Economic Exposure
Profits = e (Price – Unit Costs) Q
Transaction exposure refers to changes in the $ value of costs/revenues due to exchange rate movements
Economic exposure refers to changes in the $ value of costs/revenues due to changes in demand (caused by exchange rate movements)
![Page 3: Hedging Economic Exposure](https://reader035.vdocuments.us/reader035/viewer/2022062314/56812fc6550346895d95459b/html5/thumbnails/3.jpg)
Example: Exporting to Britain
Suppose that GM is exporting automobiles to England.
Revenues = e*P* Sales
Exchange Rate ($/L)
Price (L)
If price, and sales are constant (i.e. independent of the exchange rate) then GM only faces transaction exposure. However, if price and sales are influenced by the exchange rate, the GM faces economic exposure as well.
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“ The economic impact of currency exchange rates on us is complex because such things are often linked to real growth, inflation , interest rates, governmental actions”
Revenues = e*P* Sales
Cash flows might be functions of a lot of things that are associated with exchange rate changes!!
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Example: Suppose that Pepsi has subsidiaries in both the US and Canada. Below is Pepsi’s income statement.
Sales
USCanadian
Total
Costs of Goods Sold
USCanadian
Total
Operating Expenses
US: FixedUS: Variable
Total
EBIT
$300C$4 * .75 = $3
$303
$50C$200 * .75 = $150
$200
$30$30
$60
$43
Canadian sales and costs are unaffected by exchange rate movements, but are subject to transaction exposure
US costs are independent of the Exchange rate, but US sales rise when the Canadian dollar strengthens (Canadian goods become more expensive)
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If the Canadian Dollar Strengthens, both Costs and Sales are Affected.
Sales
USCanadian
Total
Costs of Goods Sold
USCanadian
Total
Operating Expenses
US: FixedUS: Variable
Total
EBIT
$300C$4 * .75 = $3
$303
$50C$200 * .75 = $150
$200
$30$30
$60
$43
Sales
USCanadian
Total
Costs of Goods Sold
USCanadian
Total
Operating Expenses
US: FixedUS: Variable
$310C$4 *. 80 = $3.20
$313.20
$55C$200 * . 80 = $160
$215
$30$33
1 CD = $.75 1 CD = $.80
EBIT $35.20
$63
![Page 7: Hedging Economic Exposure](https://reader035.vdocuments.us/reader035/viewer/2022062314/56812fc6550346895d95459b/html5/thumbnails/7.jpg)
What can Pepsi do to Lower its currency exposure
Pepsi could attempt to better manage its cash flows
![Page 8: Hedging Economic Exposure](https://reader035.vdocuments.us/reader035/viewer/2022062314/56812fc6550346895d95459b/html5/thumbnails/8.jpg)
Example: Suppose that Pepsi has subsidiaries in both the US and Canada. Below is Pepsi’s income statement.
Sales
USCanadian
Total
Costs of Goods Sold
USCanadian
Total
Operating Expenses
US: FixedUS: Variable
Total
EBIT
$300C$4 * .75 = $3
$303
$50C$200 * .75 = $150
$200
$30$30
$60
$43
If Pepsi could raise its Canadian Sales and lower its Canadian costs, it would be better insulated from exchange rate changes
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Increasing Canadian sales and lowering Canadian costs lowers exposure
Sales
USCanadian
Total
Costs of Goods Sold
USCanadian
Total
Operating Expenses
US: FixedUS: Variable
Total
EBIT
$300C$20 * .75 = $15
$315
$140C$100 * .75 = $75
$215
$30$30
$60
$40
Sales
USCanadian
Total
Costs of Goods Sold
USCanadian
Total
Operating Expenses
US: FixedUS: Variable
$310C$20 *. 80 = $16
$326
$145C$100 * . 80 = $80
$225
$30$33
1 CD = $.75 1 CD = $.80
EBIT $38
$63
![Page 10: Hedging Economic Exposure](https://reader035.vdocuments.us/reader035/viewer/2022062314/56812fc6550346895d95459b/html5/thumbnails/10.jpg)
Increasing Canadian sales and lowering Canadian costs lowers exposure
EBIT
E $/CD
Old Structure
New Structure
.75 .80
$43
$35.20
$40$38
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Searching for economic exposure
Economic exposure is much more general than transaction exposure (it can come from many sources). Therefore, it can be much more difficult to find!
Exchange rates change market competition
Exchange rates are correlated with Macroeconomic conditions
Exchange rates change the value of foreign currency cash flows (transaction exposure)
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Changes in currency prices can have all kinds of economic impacts. A general way to estimate economic exposure would be as follows:
ttt beaPCF
Percentage change in the exchange rate ($/F)
Percentage change in cash flows (measured in home currency)
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Regression Results
Variable Coefficients Standard Error t Stat
Intercept .05 1.5 .03
% Change in Exchange Rate -3.35 .97 -3.45
Regression Statistics
R Squared .63
Standard Error 1.20
Observations 1,000
tt beaPCF
Every 1% depreciation in the dollar relative to the British pound lowers cash flows from England by 3.35%
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Suppose you have three different facilities …
Regression Results
Variable Coefficients Standard Error t Stat
Intercept .001 2 .0005
% Change in e ($/Euro) -4.35 . 5 -8.70
You first run a regression using consolidated income statements
Plant A
Plant B
Plant C
Overall, your cash flows are negatively related to the value of the Euro
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Now, try isolating the exact location …
Regression Results
Variable Plant A Plant B Plant C
Coefficient 1.50 -4.6 -.4
T-Stat 1.2 -6.50 -1.5
Now, run a regression using individual plant income statements
Plant A
Plant B
Plant C
Aha!!! Plant B is the culprit! (And they would’ve gotten away with it if it weren’t for those meddling kids!!!)
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Now, try isolating the specific income statement items …
Regression Results
Variable SalesCost of
Goods Expenses
Coefficient -3.67 -2.23 0.02
T-Stat -5.59 -.65 4.0
Now, run a regression using individual plant income statements
Plant B
Ultimately, it looks like sales from plant B are the underlying currency problem
Sales
Costs of Goods Sold
Operating Expenses
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Now, what do we do about it?
Pricing Policy: If sales drop when the Euro appreciates, then consider lowering prices during strong Euro periods to maintain market share
Cash flow matching: If sales (and hence, cash inflows) are dropping during periods with a weak dollar, try adjusting production locations so that your costs will drop at the same time.
Futures, Forwards, and Options