ECONOMIC EXPOSURE

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ECONOMIC EXPOSURE
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Agenda

1. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
2. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE
   CHANGES
3. IDENTIFYING ECONOMIC EXPOSURE

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CONCEPT OF FOREIGN EXCHANGE EXPOSURE

• Economic exposure focuses on the impact of
  currency fluctuations on the firms value.
• Expectations about fluctuations must be
  incorporated in all basic decisions of the firm.
• Definitions
• Accounting exposure impact on firms balance
  sheet
• Economic exposure
• Cash Flow exposure
• Net worth exposure

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Definition

• Economic Exposure The risk that exchange rate
  changes may affect the present value of future
  income streams.

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Case 1 No Deviation From PPP

• An example of a U.S corporations British
  Subsidiary
• Assumption PPP holds
• Nominal ER ? - ? ?S
• Domestic inflation less foreign inflation should
  equal the change in the spot rate.
• Implies that the higher inflation country should
  see its currency depreciate.? depreciation of
  is the result of higher inflation in UK than in
  U.S

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No Deviation From PPP

• price of the product will rise in accordance
  with British inflation
• Results
• price
• AC
• margin No change
• Volume
• Profit

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Case 2 Real ER changes and self-contained
subsidiary-Price-Taker

• Perfectly competitive market
• British operation services the local market and
  undertakes all production locally
• depreciates in real term
• Price not change price taker
• Price change
• Costs change
• Profit margin Decline in proportion of ER
  change

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Real ER changes and self-contained
subsidiary-Price-Taker

MC
AC
MR
Po
MR
P1
Co
C1
Q0
Quantity
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Real ER changes and self-contained
subsidiary-Price-Maker

• The result is the same Why
• denominated demand curve no change with the
  depreciation of
• equivalent demand curse shift down
• Price not change no change in D
• Price change
• Costs change
• Profit margin Decline in proportion of ER
  change

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Case 3 Real ER and a World Output Market

• Assumption
• British subsidiary functions in a world market
  for output
• The world price is determined in (MRMR)
• Results of depreciation
• Change the cost structure because of the local
  inputs
• Increase the production
• ? Increase profit

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Real ER and a World Output Market
MC

MC
AC
AC
MRMR
Po
Co
C1
Quantity
Q0
Q1
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Case 4 Real ER and a World Input Market

• Assumption
• Output is priced in
• Input is priced in (MRMR)
• Results of depreciation
• Shift the MR down
• Cost function does not shift down
• ? cut production to reduce costs? profit
  declines

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Case 5 Real ER and a World Input Output Market

• Assumption
• Competing in a world of output
• Producing the output with factors supplied in a
  world input market
• Results of depreciation
• No shift the MR
• No shift the cost function? no economic exposure

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ConclusionLocal Currency Depreciation
Cases U.S Dollar Price U.S. Dollar AC U.S Dollar Margin Volume U.S Dollar Profit
PPP holds No Change No Change No Change No Change No Change
Real Depreciation and self-contained Decrease Decrease Decrease No Change Decrease
Real Depreciation, world output Price Taker No change Price Maker Decrease Increase Increase Increase
Real Depreciation, world input Decrease No change Decrease Decrease Decrease
Real Depreciation, world output input No change No change No change No change No change