CHAPTER 11CHAPTER 11

MEASURING MEASURING ECONOMIC ECONOMIC EXPOSUREEXPOSURE

CHAPTER OVERVIEW

I.I. Foreign Exchange Risk and Foreign Exchange Risk and Economic Economic ExposureExposure

II.II. The Economic Consequences of The Economic Consequences of Exchange Rate ChangesExchange Rate Changes

IIIIII.. Identifying Economic ExposureIdentifying Economic Exposure

IV.IV. Calculating Economic ExposureCalculating Economic Exposure

V.V. An Operational Measure of Exchange An Operational Measure of Exchange Rate RiskRate Risk

Part I.Part I. Foreign Exchange Risk and Foreign Exchange Risk and Economic ExposureEconomic Exposure

I.I. FOREIGN EXCHANGE RISKFOREIGN EXCHANGE RISK

A.A. Economic exposureEconomic exposure

focuses on the impact of currency focuses on the impact of currency fluctuations on firm’s value.fluctuations on firm’s value.

1 .1 . Expectations about the Expectations about the fluctuation must be fluctuation must be incorporated in all basicincorporated in all basic

decisions of the firm.decisions of the firm.

FOREIGN EXCHANGE RISK AND FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSUREECONOMIC EXPOSURE

2.2.Definitions:Definitions:

a.a. Accounting exposureAccounting exposure

impact on firm’s balance sheetimpact on firm’s balance sheet

b.b. Economic exposureEconomic exposure

1.)1.) Transaction Transaction

2.)2.) OperatingOperating

FOREIGN EXCHANGE RISK AND FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSUREECONOMIC EXPOSURE

THE REAL EXCHANGE RATETHE REAL EXCHANGE RATE

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FOREIGN EXCHANGE RISK AND FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSUREECONOMIC EXPOSURE

B.B. Real Exchange Rates and RiskReal Exchange Rates and Risk

1.1. Nominative v. real exchange ratesNominative v. real exchange rates

real rate has been adjusted forreal rate has been adjusted for

price changes.price changes.

2.2. Hobson’s Choice:Hobson’s Choice:when faced with a change in real value,when faced with a change in real value,

do you keep price constant (changingdo you keep price constant (changingsales) or change prices (change sales) or change prices (change profits)profits)

FOREIGN EXCHANGE RISK AND FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSUREECONOMIC EXPOSURE

3.3. SUMMARYSUMMARY

a.a. the economic impact of a the economic impact of a currency change depends on the currency change depends on the offset by the difference in inflation offset by the difference in inflation rates or the real exchange rate.rates or the real exchange rate.

b.b. It is the relative price changes It is the relative price changes

that ultimately determine a firm’s that ultimately determine a firm’s

long-run exposure.long-run exposure.

PART II. THE ECONOMIC PART II. THE ECONOMIC CONSEQUENCES OF EXCHANGE CONSEQUENCES OF EXCHANGE RATE CHANGESRATE CHANGES

II.II. ECONOMIC CONSEQUENCESECONOMIC CONSEQUENCES

A. Transaction exposureA. Transaction exposure

1.1. On-balance sheetOn-balance sheet

2.2. Off-balance sheetOff-balance sheet

THE ECONOMIC CONSEQUENCES THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES OF EXCHANGE RATE CHANGES

II.II. ECONOMIC CONSEQUENCES (con’t)ECONOMIC CONSEQUENCES (con’t)

B. Operating Exposure : real rate B. Operating Exposure : real rate changechange

1.1. Pricing flexibility is key.Pricing flexibility is key.

2.2. Product differentiationProduct differentiation

3.3. Substitution of inputsSubstitution of inputs

THE ECONOMIC CONSEQUENCES THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES OF EXCHANGE RATE CHANGES

II.II. SUMMARYSUMMARY

The sector of the economy in which The sector of the economy in which the firm operates;the firm operates;

the sources of the firm’s inputs;the sources of the firm’s inputs;

andand

fluctuations in the real exchange ratefluctuations in the real exchange rate

delineate the firm’s true economicdelineate the firm’s true economic

exposure.exposure.

PART III. IDENTIFYING PART III. IDENTIFYING ECONOMIC EXPOSUREECONOMIC EXPOSURE

III.III. CASE STUDIES OF ECONOMIC CASE STUDIES OF ECONOMIC EXPOSUREEXPOSURE

A.A. ASPEN SKIING COMPANYASPEN SKIING COMPANY

1.1. Firm’s exchange rate risk Firm’s exchange rate risk affectedaffected

its sales revenues.its sales revenues.

PART III. IDENTIFYING PART III. IDENTIFYING ECONOMIC EXPOSUREECONOMIC EXPOSURE

A.A. ASPEN SKIING COMPANY (con’t)ASPEN SKIING COMPANY (con’t)

2.2. Although there was no translationAlthough there was no translation

risk, the global market with its risk, the global market with its

exchange rate risk and exchange rate risk and its its

competitors competitors impacted market demandimpacted market demand

PART III. IDENTIFYING PART III. IDENTIFYING ECONOMIC EXPOSUREECONOMIC EXPOSURE

B.B. PETROLEOS MEXICANOS (PEMEX)PETROLEOS MEXICANOS (PEMEX)

1.1. The firm’s exchange rate riskThe firm’s exchange rate risk

affected cost but not revenues.affected cost but not revenues.

2.2. Economic impactEconomic impact

a.a. Revenues: noneRevenues: none

b.b. Costs:Costs: decreaseddecreased

c.c. Net effect:Net effect: increased increased US$ US$ flows flows

IDENTIFYING ECONOMIC IDENTIFYING ECONOMIC EXPOSUREEXPOSURE

C.C. TOYOTA MOTOR COMPANYTOYOTA MOTOR COMPANY

1.1. Exchange rate risk affected Exchange rate risk affected BOTHBOTH

revenues and costs.revenues and costs.

2.2. Flow back effect:Flow back effect:

previously exported goods returnpreviously exported goods return

with increased domestic with increased domestic competition.competition.

3.3. Lower profit margins domesticallyLower profit margins domestically

PART IV. CALCULATING PART IV. CALCULATING ECONOMIC EXPOSUREECONOMIC EXPOSURE

IV.IV. A quantitative assessment of A quantitative assessment of economiceconomic

exposure depends on underlying exposure depends on underlying assumptions concerning:assumptions concerning:

A.A. future cash flows;future cash flows;

B.B. sensitivity to exchange ratesensitivity to exchange rate

changes.changes.

PART V. AN OPERATIONAL PART V. AN OPERATIONAL MEASURE OF EXCHANGE RISKMEASURE OF EXCHANGE RISK

V.V. NEED FOR A WORKABLE APPROACH NEED FOR A WORKABLE APPROACH

A.A. Regression AnalysisRegression Analysis

1.1. VariablesVariables

a.a. Independent: Independent:

changes in parent’s cash changes in parent’s cash flowsflows

b.b. Dependent:Dependent:

Average nominal exchange Average nominal exchange rate rate change.change.

AN OPERATIONAL MEASURE AN OPERATIONAL MEASURE OF EXCHANGE RISKOF EXCHANGE RISK

B. REGRESSION EQUATIONB. REGRESSION EQUATION

-approach based on the operational -approach based on the operational definition of the exchange risk faced by a definition of the exchange risk faced by a parent or one of its affiliates:parent or one of its affiliates:

--a company faces exchange risk to the a company faces exchange risk to the extent that variations in the dollar value of extent that variations in the dollar value of the unit’s cash flows are correlated with the unit’s cash flows are correlated with variations in the nominal exchange ratevariations in the nominal exchange rate

AN OPERATIONAL MEASURE AN OPERATIONAL MEASURE OF EXCHANGE RISKOF EXCHANGE RISK

where CFwhere CFt t = = CFCFt t - - CF CFt-1t-1 is the dollar is the dollar

value of total affiliate(parent) value of total affiliate(parent) cash flows in period tcash flows in period t

EXCHEXCHtt = = EXCH EXCHtt - EXCH - EXCHt-1t-1 equals the equals the

average nominal exchange rate average nominal exchange rate during period tduring period t

u =u = a random error terma random error term

ttt uEXCHaCF

AN OPERATIONAL MEASURE AN OPERATIONAL MEASURE OF EXCHANGE RISKOF EXCHANGE RISK

1.1.Output measures:Output measures:

a.a. Beta coefficient (Beta coefficient (measures the association of measures the association of changes in cash flows to changes in cash flows to exchange rate changes.exchange rate changes.

AN OPERATIONAL MEASURE AN OPERATIONAL MEASURE OF EXCHANGE RISKOF EXCHANGE RISK

b.b. the higher the percentage the higher the percentage change of cash flow to change of cash flow to changes in exchange rates, changes in exchange rates, the greater the economic the greater the economic exposure (higher beta values).exposure (higher beta values).

AN OPERATIONAL MEASURE OF AN OPERATIONAL MEASURE OF EXCHANGE RISKEXCHANGE RISK

VI.VI. SUMMARY:SUMMARY:

A.A. The focus of the accounting The focus of the accounting profession on the balance sheet profession on the balance sheet impact of currency changes has impact of currency changes has led to ignoring the important led to ignoring the important impact on future cash flows.impact on future cash flows.

AN OPERATIONAL MEASURE OF AN OPERATIONAL MEASURE OF EXCHANGE RISKEXCHANGE RISK

B.B. For firms incurring costs and selling For firms incurring costs and selling products in foreign countries, the net products in foreign countries, the net

effect of currency changes may effect of currency changes may be less be less important in the long run.important in the long run.

AN OPERATIONAL MEASURE OF AN OPERATIONAL MEASURE OF EXCHANGE RISKEXCHANGE RISK

C. C. To measure exposure properly, you To measure exposure properly, you must focus on inflation-adjusted or must focus on inflation-adjusted or

real real exchange rates instead of nominal or exchange rates instead of nominal or actual exchange rates.actual exchange rates.

AN OPERATIONAL MEASURE OF AN OPERATIONAL MEASURE OF EXCHANGE RISKEXCHANGE RISK

D.D. It is difficult in practice to determine It is difficult in practice to determine what the actual economic impact of a what the actual economic impact of a currency change will be.currency change will be.