CHAPTER 11

Measuring and Managing Economic

Exposure

PART I. FOREIGN EXCHANGE RISK AND ECONOMIC

EXPOSURE

I. FOREIGN EXCHANGE RISKA. Economic exposure

focuses on the impact of currencyfluctuations on firm’s value.1 . The most important aspect of

foreign exchange risk management:

Incorporate expectations about the Incorporate expectations about the risk into all basic decisions of the risk into all basic decisions of the firm.firm.

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

2. Definition:Economic exposure =

Transaction exposure +

Operating exposure:

arises because currency fluctuations alter a

company’s future revenues and

expenses.

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

To measure operating exposure requires a longer-term perspective.

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

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

Operating Exposure begins:the moment a firm starts to invest in a market subject to foreign competition or in sourcing goods or inputs abroad

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

The new investment includes:New product development

A distribution network

Brand name development

Marketing

Foreign supply contracts

Production facilities

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

B. Real Exchange Rates Changes and Risk

Nominal v. real exchange rates:

real rate has been adjusted for

price changes.

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

C. Implications1. 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.

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

A declinedecline in the real value of a currency:

makes exports and import-competing goods more competitive

An appreciating appreciating currency makes:

imports and export-competing goods more competitive

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

During an appreciation of home currencies:

Exporters face two choices:

#1 keep prices constant (but lose sales)

or

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

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

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.

PART II. THE ECONOMIC CONSEQUENCES OF EXCHANGE

RATE CHANGES

I. ECONOMIC CONSEQUENCESThe impact on Operating Exposure of a

real rate change depends upon:

Pricing flexibility and

1. Price elasticity of demand2. Degree of product differentiation

3. The Ability to shift production and

the substitution of inputs

If HC Appreciates

Pricing Flexibility is keyPricing Flexibility is key

If HC Appreciates

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

If HC Appreciates

Product DifferentiationProduct Differentiationprice elasticity depends on degree of

differentiation

The greater the differentiation, the more the firm can control its prices.

e.g. Mercedes Benz cars

If HC Appreciates

The Ability to Shift Production and to source The Ability to Shift Production and to source inputs from other countriesinputs from other countries

e.g. Japanese car makers in the late 1980’s

PART II.MANAGING OPERATING EXPOSURE

I. INTRODUCTIONOperating exposure management requires long-term operating adjustments and the involvement of all departments.

MANAGING OPERATING EXPOSURE

II. Marketing StrategyMarketing StrategyA. Market Selection:

use competitive advantage to carve out market share when currency values change

MANAGING OPERATING EXPOSURE

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.

MANAGING OPERATING EXPOSURE

C. Product Strategy

exchange rate changes may alter1. The timing of new product

introductions,

2. Product deletion

3. Product innovations

MANAGING OPERATING EXPOSURE

III. Product Management Adjustments

A. Input mix “shop the world”

B. Shift production among plants

C. Plant relocation

D. Raising productivity

MANAGING OPERATING EXPOSURE

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 mfg systems

MANAGING OPERATING EXPOSURE

V. Financial Management of Exchange Rate Risk:

Financial manager’s RoleFinancial 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.

MANAGING OPERATING EXPOSURE

A. Provide local manager with

forecasts of inflation and exchange-rate changes.

B. Identify and focus on competitive exposure.

MANAGING OPERATING EXPOSURE

C. Design the evaluation criteria so that operating managers neither

rewarded or penalized for unexpected exchange-rate changes.