MANAGING AND MEASURING ECONOMIC EXPOSURE

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CHAPTER 11

• MANAGING AND MEASURING ECONOMIC EXPOSURE

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CHAPTER OVERVIEW

• I. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE
  CHANGES ON THE FIRM
• II. IDENTIFYING ECONOMIC EXPOSURE
• III. MANAGING OPERATING EXPOSURE

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Economic Exposure

• Value of the firm
• Suppose the firm produces and sells all its
  products in one foreign country.
• Suppose an unexpected devaluation of ½ occurs.

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Economic Exposure

• Does this devaluation have transaction exposure
  implications?
• Where is the vast majority of the exposure?
• This is operating exposure.

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Economic Exposure

• In the example, the exchange rate change was a
  real change.
• et real rate (inflation adjusted)
• et nominal rate
• if,t foreign inflation ih,t home inflation

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Economic Exposure

• Let
• e0 100 e0
• if,t 10
• ih,t 20
• Any effect on real competitiveness of domestic
  versus foreign firms?

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Economic Exposure

• However, suppose the nominal rate remains the
  same through intervention.
• Now is there an effect on competitiveness?

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Economic Exposure

• A higher real exchange rate implies
• - foreign currency costs more in real terms
• - goods from there are more expensive
• - exports to there are less expensive
• - competitors in that country are disadvantaged
• Govts who fix nominal rate while controlling
  inflation do this.

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Economic Exposure

• If real value of the home currency appreciates
• - foreign currency costs less in real terms
• - goods from there are less expensive
• - exports to there are more expensive
• - competitors from that country have an
  advantage
• Govts who fix nominal rate while allowing
  inflation to increase do this.

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Economic Exposure

• The degree of operating exposure is unique to
  each firm and depends on the firms pricing
  flexibility.
• Depends of price elasticity of demand how an
  increase in price affects the quantity of goods
  demanded.

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Economic Exposure
Normal is e lt 0, i.e., increases in price lead to
decreases in demand and vice versa.
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Economic Exposure
Example Suppose Fun Boards of Portland builds
surf boards with some sales in Australia. P0
A 1,000 e0 1.15/A (Real rate) P
A1,000x1.15/A 1,150
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Economic Exposure
Example What if real rate changed to e0
.92/A, a 20 depreciation? P A1,000 x
0.92/A 920 A loss of 1,150 920 230
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Economic Exposure
If the boards are inelastic (e0), Fun Boards
could just increase their price and maintain
profits. 1,150 0.92/A x Pnew Pnew
1,150 A1,250 0.92/A And they should be
able to sell as many boards as before.
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Economic Exposure
If demand is elastic (elt0), demand is affected by
increases in price, i.e., fewer boards will be
sold.Fun Boards could just increase their price
and maintain profits. If perfectly elastic then
any increase in price will lead to a total
collapse in demand. In this case Fun Boards will
have to live with P 920
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Economic Exposure

• Price elasticity depends on
• Product differentiation
• Location of competition
• Location of suppliers

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Economic Exposure
If boards are highly differentiated will buyers
be more or less likely to pay more?
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Economic Exposure
If competing board manufacturers in Australia are
all American then how will the competition be
affected by the depreciation? If competing board
manufacturers in Australia are all Australian,
how will the competition be affected by the
deprecation?
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Economic Exposure
If Fun Boards buys its raw materials from
Australian suppliers, how will their home
currency costs be affected by the
depreciation? If their suppliers are American,
how will their home currency costs be affected by
the depreciation? In which case can they drop
board prices?
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Economic Exposure
The role of the financial manager is to structure
liabilities in such a way that any reduction in
dollar cash flow is offset by a reduction in
dollar liabilities. For example, if 50 of sales
are from Australia, then Fun Boards could raise
50 of their financing needs from Australia.
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Economic Exposure

• Major ways to cope with economic exposure
• are related to marketing and production
• Are strategic in nature
• And must anticipate problems and preplan ways to
  cope with them.

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Economic Exposure

• Marketing Market selection and segmentation
• Be quick to take advantage of appreciating
  currencies, local competitors are disadvantaged
• Demand for differentiated, higher-end products is
  relatively inelastic.

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Economic Exposure

• Marketing Pricing market share or profits
• Market share?
• Profit margin?
• When local currency devalues
• Maintain local currency price share?
• Raise local currency price share?

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Economic Exposure

• Production management
• Input mix simply import more raw materials in
  devalued currencies.
• Effect on input costs?
• Effect on labor costs?

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Economic Exposure

• Production management
• 2. Shift production produce more in plants
  whose local currencies have devalued and less in
  plants whose currencies have appreciated.
• Effect on input costs?
• Effect on labor costs?
• Assumptions?

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Economic Exposure

• Production management
• 3. Plant location major determinant should be
  economic exposure to currency fluctuations.
  Choices
• Build in major foreign product market?
• Build in third-world country with low labor costs
  and import back home?

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Economic Exposure

• Production management
• 4. Improve productivity / cost efficiency by
• Closing old, inefficient plants.
• Automating.
• Negotiate wage and benefits cuts
• How does this help the firm compete?

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Measuring Economic Exposure

• REGRESSION EQUATION
• -approach based on the operational definition
  of the exchange risk faced by a parent or one of
  its affiliates
• -a company faces exchange risk to the extent
  that variations in the dollar value of the units
  cash flows are correlated with variations in the
  nominal exchange rate

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Measuring Economic Exposure

• where ?CFt CFt - CFt-1
• CFt is the dollar value of total parent
  cash flows in period t
• ?EXCHt et - et-1
• the change in the nominal exchange rate
  during period t
• u a random error term

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Measuring Economic Exposure
Regression coefficient (b) measures the relation
between changes in cash flows and changes in spot
exchange rates. The higher is b, the greater the
economic exposure of the company.