Measuring and Measuring and Managing Economic Managing Economic ExposureExposure

Chapter 10Chapter 10

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Steps to the Creation of Steps to the Creation of an Economic Exposure an Economic Exposure StrategyStrategyStep 1. Step 1. Identifying the exposureIdentifying the exposure

Step 2.Step 2. Define the riskDefine the risk

Step 3.Step 3. List the operating exposuresList the operating exposures

Step 4.Step 4. Measuring economic Measuring economic exposureexposure

Step 5.Step 5. Guidelines to create strategyGuidelines to create strategy

Step 6.Step 6. Methods to manage riskMethods to manage risk

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IDENTIFYING FOREIGN IDENTIFYING FOREIGN EXCHANGE RISK AND EXCHANGE RISK AND ECONOMIC EXPOSUREECONOMIC EXPOSUREI.I. FOREIGN EXCHANGE RISK: FOREIGN EXCHANGE RISK: Step IStep I..

A.A. Economic exposure defined:Economic exposure defined:focuses on the focuses on the futurefuture impact of impact of

unexpectedunexpected currency currency fluctuations on fluctuations on firm’s value.firm’s value.

1 .1 . The The most importantmost important aspect of aspect of foreign exchange risk foreign exchange risk management:management: Incorporate expectations Incorporate expectations about the risk into all basic about the risk into all basic decisions of the firm.decisions of the firm.

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Step 2.Step 2. Define the riskDefine the risk

2.2. Definition:Definition:

Economic exposure =Economic exposure =

Transaction exposure +Transaction exposure +

Operating exposure:Operating exposure:

arises because currency arises because currency fluctuations alter a fluctuations alter a company’s future company’s future revenues revenues and expenses.and expenses.

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FOREIGN EXCHANGE RISK FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSUREAND ECONOMIC EXPOSURE

B.B. Real Exchange Rates Changes and Real Exchange Rates Changes and RiskRiskNominal v. real exchange Nominal v. real exchange rates:rates:real rate has been adjusted real rate has been adjusted forforprice changes.price changes.

Assume: no two nations have the same Assume: no two nations have the same annual rate of inflation.annual rate of inflation.

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FOREIGN EXCHANGE RISK FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSUREAND ECONOMIC EXPOSURE

C. ImplicationsC. Implications1. If nominal rates change with an 1. If nominal rates change with an

equal price change, no equal price change, no alteration to cash flows. alteration to cash flows.

*2. If real rates change, it causes *2. If real rates change, it causes relative price changes and relative price changes and changes in purchasing power.changes in purchasing power.

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FOREIGN EXCHANGE RISK FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSUREAND ECONOMIC EXPOSURE

Operating Exposure begins:Operating Exposure begins:

the moment a firm starts to the moment a firm starts to invest in a market subject to invest in a market subject to foreign competitionforeign competition

oror

in in sourcing sourcing goods or inputs goods or inputs abroadabroad

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Step 3Step 3 List the new risksList the new risks

Operating exposure begins withOperating exposure begins withNew product developmentNew product development

A distribution networkA distribution network

Brand name developmentBrand name development

Marketing to foreign marketsMarketing to foreign markets

Foreign supply contractsForeign supply contracts

Overseas production facilitiesOverseas production facilities

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Step 4. Step 4. Measuring Measuring economic exposureeconomic exposure

To measure operating To measure operating exposure requires a exposure requires a

longer-term longer-term perspective.perspective.

i.e. Cost and price i.e. Cost and price competitiveness could be competitiveness could be affected by unexpected affected by unexpected

exchange exchange rate rate changeschanges

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FOREIGN EXCHANGE RISK FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSUREAND ECONOMIC EXPOSURE

A A declinedecline in the real value of a in the real value of a currency:currency:

makes exports and import-competing makes exports and import-competing goods more competitivegoods more competitive

An An appreciating appreciating currency makes:currency makes:

imports and export-competing goods imports and export-competing goods more competitivemore competitive

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FOREIGN EXCHANGE RISK FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSUREAND ECONOMIC EXPOSURE

During an appreciation of home During an appreciation of home currencies:currencies:

Exporters face Exporters face two choicestwo choices::

keep prices constant (but lose keep prices constant (but lose sales)sales)

oror

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

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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 currency change depends

on the on the offset by the difference offset by the difference in inflation in inflation rates or the change in rates or the change in real real exchange rates.exchange rates.

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

that ultimately determine a that ultimately determine a

firm’s firm’s long-run exposure. long-run exposure.

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Step 5. Step 5. Guidelines to Guidelines to create a strategycreate a strategy

I.I. ECONOMIC CONSEQUENCESECONOMIC CONSEQUENCES

The impact on Operating Exposure of The impact on Operating Exposure of a a real rate change depends upon:real rate change depends upon:

Pricing flexibility andPricing flexibility and

1.1. Price elasticity of demandPrice elasticity of demand2.2. Degree of product Degree of product

differentiationdifferentiation

3.3. The Ability to shift production The Ability to shift production and the substitution of inputsand the substitution of inputs

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If HC AppreciatesIf HC Appreciates

Pricing Flexibility is keyPricing Flexibility is key

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If HC AppreciatesIf HC Appreciates

Can the firm maintain its profit margins Can the firm maintain its profit margins both at home and abroad?both at home and abroad?

If If price elasticity of demandprice elasticity of demand is low, the is low, the more price flexibility a firm has.more price flexibility a firm has.

i.e. Availability of good substitutesi.e. Availability of good substitutes

The Ford Corp in Indonesia, The Ford Corp in Indonesia, 19971997

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If HC AppreciatesIf HC Appreciates

Product DifferentiationProduct Differentiation

price elasticity depends on degree price elasticity depends on degree of differentiationof differentiation

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

e.g. Daimler Chrysler Corp.e.g. Daimler Chrysler Corp.

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If HC AppreciatesIf HC Appreciates

The Ability to Shift Production and The Ability to Shift Production and to source inputs from other to source inputs from other countriescountries

e.g. Japanese car makers e.g. Japanese car makers (Toyota) (Toyota) in the latein the late

1980’s1980’s

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Step 6.Step 6. Strategies to Strategies to manage economic manage economic exposureexposureI.I. INTRODUCTIONINTRODUCTION

Operating exposure Operating exposure management requires management requires long-term long-term operating adjustments and operating adjustments and

the the involvement of ALL involvement of ALL departmentsdepartments..

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MANAGING OPERATING MANAGING OPERATING EXPOSUREEXPOSURE

II.II. Marketing StrategyMarketing Strategy

A. Market Selection:A. Market Selection:

use competitive use competitive advantage to advantage to carve out carve out market share when market share when currencycurrency values changevalues change

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MANAGING OPERATING MANAGING OPERATING EXPOSUREEXPOSURE

B.B. Pricing strategy: Expectations criticalPricing strategy: Expectations critical

1.1. If HC depreciates, exporter gainsIf HC depreciates, exporter gains

competitive advantage by competitive advantage by increasing unit profitability increasing unit profitability

or or market share.market share.

2.2. The higher price elasticity of The higher price elasticity of demand, the more currency demand, the more currency

riskrisk

the firm faces by other product the firm faces by other product substitution.substitution.

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MANAGING OPERATING MANAGING OPERATING EXPOSUREEXPOSURE

C.C. Product StrategyProduct Strategy

exchange rate changes may alterexchange rate changes may alter

1.1. The timing of new product The timing of new product introductions,introductions,

2.2. Product deletion Product deletion

3.3. Product innovations Product innovations

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MANAGING OPERATING MANAGING OPERATING EXPOSUREEXPOSUREIII.III. Product Management Product Management

AdjustmentsAdjustments

A.A. Input mix “shop the world”Input mix “shop the world”

B.B. Shift production among Shift production among plantsplants

C.C. Plant relocation (new)Plant relocation (new)

D.D. Raising productivityRaising productivity

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MANAGING OPERATING MANAGING OPERATING EXPOSUREEXPOSURE

IV.IV. Planning For Exchange-Rate Planning For Exchange-Rate ChangesChanges

A.A. Develop contingency plansDevelop contingency plans

with plausible scenarioswith plausible scenarios

before the impact of abefore the impact of acurrency change makes currency change makes

itself itself felt.felt.

e.g. e.g. flexible mfg systemsflexible mfg systems