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Measuring and ManagingEconomic Exposure


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Economic Exposure

Changes in exchange rates can affect not onlyfirms that are directly engaged in internationaltrade but also purely domestic firms.

Economic exposure can be defined as the extentto which the value of the firm would be affected byunanticipatedchanges in exchange rates.


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Economic Exposure

Exchange rate risk as applied to thefirms competitive position.

Any anticipated changes in the exchangerates would have been already

discounted and reflected in the firmsvalue.


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Foreign Exchange Risk:Economic exposure focuses on the impact of currencyfluctuations on firms value.

The most important aspect of foreign exchange riskmanagement:

Incorporate expectations about the risk into all basicdecisions of the firm

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Foreign Exchange Risk

And Economic Exposure


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Economic exposure =Transaction exposure +OperatingexposureOperating exposure:

arises because currency fluctuations alter a companysfuture revenues and expenses

Transaction exposureThe risk, faced by companies involved in international

trade, that currency exchange rates will change afterthe companies have already entered into financialobligations

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To measure operating exposure requires a longer-term perspective.

i.e. Cost and price competitiveness could beaffected by exchange rate changes

Operating Exposure begins:the moment a firm starts to invest in a marketsubject to foreign competition or in sourcing goodsor inputs abroad

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Measure EconomicExposure If a U.S. MNC were to run a regression on the dollar value

(P) of its British assets on the dollar pound exchange rate,S($/), the regression would be of the form:

P = a + bS + e

Where

a is the regression constant

e is the random error term with mean zero.

P is the dollar value of total

The regression coefficient b measures the sensitivity of the

dollar value of the assets (P) to the exchange rate, S

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Measure EconomicExposure The exposure coefficient, b, is defined as follows:

Where Cov(P,S) is the covariance between the dollarvalue of the asset and the exchange rate, andVar(S) is the variance of the exchange rate.

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Cov(P,S)Var(S)

b =


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Foreign Exchange Risk AndEconomic Exposure The new investment includes:

New product development

A distribution network

Brand name development Marketing

Foreign supply contracts

Production facilities

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FOREIGN EXCHANGE RISKAND ECONOMIC EXPOSURE

B. Real Exchange Rates Changes andRiskNominal v. real exchange rates:

real rate has been adjusted forprice changes.

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FOREIGN EXCHANGE RISKAND ECONOMIC EXPOSURE

Implications of nominal vs real:1. If nominal rates change with an equal

price change, no alteration to cash

flows

2. If real rates change, it causes relativeprice changes and changes in

purchasing power

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TALAL

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Currency

A declinedecline in the real value of a currency:makes exports and import-competing goodsmore competitive

An appreciatingappreciatingcurrency makes:makes imports and export-competing goodsmore competitive

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Currency

During an appreciation of homecurrencies:

Exporters face two choices:

#1 keep prices constant (but lose sales)or

#2 adjust prices to foreign currency tomaintain market share (lose profits)

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a. the economic impact of acurrency change depends on theoffset by the difference in inflation rates

or the change in real exchange rates

b. It is the relative price changes that ultimately

determine a firms long-run exposure

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Currency


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The Economic Consequences OfExchange Rate Changes

Economic ConsequencesEconomic ConsequencesThe impact on Operating Exposure of a real rate change

depends upon:

Pricing flexibility which include;

1. Price elasticity of demand2. Degree of product differentiation

3. The Ability to shift production and

the substitution of inputs

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If HC Appreciates

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Pricing Flexibility is keyPricing Flexibility is key


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If HC Appreciates

Can the firm maintain its profit margins bothat home and abroad?

1.The Price Elasticity of Demand (known as just price elasticity)

measures the rate of response of quantity demanded due to a pricechange.

If price elasticity of demand is low, the more price flexibilitya firm has

ToTo calculating the price elasticity of demand:calculating the price elasticity of demand:

Ed(% Change in Quantity Demanded)/(% Change in Price)

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If HC Appreciates

2. Product Differentiation

ProductDifferentiation looks to make a product moreattractive by contrasting its unique qualities with othercompeting products.

price elasticity depends on the degree of differentiation

The greater the differentiation, the more the firm cancontrol its prices

e.g. Mercedes Benz autos

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If HC Appreciates

3.3. The Ability to Shift Production and toThe Ability to Shift Production and tosource inputs from other countriessource inputs from other countries

e.g. The lack of ability of Japanese car makersin the late 1980s

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Kalied

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Managing Operating

Exposure

I. INTRODUCTION

Operating exposure management requireslong-term operating adjustments and theinvolvement of all departments.

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Managing Operating

Exposure II. Marketing StrategyMarketing Strategy

A. Market Selection:

use competitive advantage to carveout market share when currencyvalues change

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Managing Operating

ExposureB. Pricing strategy:

1. If HC depreciates, exporter gains

competitive advantage by increasing unitprofitability or market share

2. The higherprice elasticity of demand, themore currency risk the firm faces by other

product substitution

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Managing Operating

ExposureC. Product Strategy

exchange rate changes may alter

1. The timing of new productintroductions

2. Product deletion

3. Product innovations

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Managing Operating

ExposureIII. Product Management AdjustmentsA. Input mix shop the world

B. Shift production among plants

C. Plant relocationD. Raising productivity

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Managing Operating

ExposureIV. Planning For Exchange-RateChangesA. Develop contingency plans with plausible

scenarios before the impact of a currencychange makes itself felt

e.g. flexible mfg systems

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Managing Operating

ExposureV. Financial Management of Exchange

Rate Risk:

Financial managers RoleFinancial managers RoleStructure the firms liabilities insuch a way that the reduction inasset earnings is matched by

corresponding decrease in costof servicing liabilities.

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Managing Operating

ExposureA. Provide local manager withforecasts of inflation and exchange-rate

changes.

B. Identify and focus on competitive exposure.

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Managing Operating

ExposureC. Design the evaluation criteriaso that operating managers neither rewarded

or penalized for unexpected exchange-rate

changes

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