Measuring and Managing Economic Exposure Chapter 10 * * *

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Measuring and Managing Economic Exposure

• Chapter 10

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Steps to the Creation of an Economic Exposure
Strategy

• Step 1. Identifying the exposure
• Step 2. Define the risk
• Step 3. List the operating exposures
• Step 4. Measuring economic exposure
• Step 5. Guidelines to create strategy
• Step 6. Methods to manage risk

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IDENTIFYING FOREIGN EXCHANGE RISK AND ECONOMIC
EXPOSURE

• I. FOREIGN EXCHANGE RISK Step I.
• A. Economic exposure defined
• focuses on the future impact of unexpected
  currency fluctuations on firms value.
• 1 . The most important aspect of foreign
  exchange risk management
• Incorporate expectations about the risk
  into all basic decisions of the firm.

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Step 2. Define the risk

• 2. Definition
• Economic exposure
• Transaction exposure
• Operating exposure
• arises because currency fluctuations
  alter a companys future revenues and
  expenses.

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

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• C. Implications
• 1. 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.

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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

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Step 3 List the new risks

• Operating exposure begins with
• New product development
• A distribution network
• Brand name development
• Marketing to foreign markets
• Foreign supply contracts
• Overseas production facilities

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Step 4. Measuring economic exposure

• To measure operating exposure requires a
  longer-term perspective.
• i.e. Cost and price competitiveness
  could be affected by unexpected exchange rate
  changes

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• A decline in the real value of a currency
• makes exports and import-competing goods more
  competitive
• An appreciating currency makes
• imports and export-competing goods more
  competitive

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• During an appreciation of home currencies
• Exporters face two choices
• keep prices constant (but lose sales)
• or
• adjust prices to foreign currency to maintain
  market share (lose profits)

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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 firms long-run
  exposure.

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Step 5. Guidelines to create a strategy

• I. ECONOMIC CONSEQUENCES
• The impact on Operating Exposure of a real
  rate change depends upon
• Pricing flexibility and
• 1. Price elasticity of demand 2. Degree of
  product differentiation
• 3. The Ability to shift production and the
  substitution of inputs

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If HC Appreciates

Pricing Flexibility is key
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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
• The Ford Corp in Indonesia, 1997

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If HC Appreciates

• Product Differentiation
• price elasticity depends on degree of
  differentiation
• The greater the differentiation, the more the
  firm can control its prices.
• e.g. Daimler Chrysler Corp.

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If HC Appreciates

• The Ability to Shift Production and to source
  inputs from other countries
• e.g. Japanese car makers (Toyota) in the
  late 1980s

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Step 6. Strategies to manage economic exposure

• I. INTRODUCTION
• Operating exposure management requires long-term
  operating adjustments and
• the involvement of ALL departments.

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MANAGING OPERATING EXPOSURE

• II. Marketing Strategy
• A. Market Selection
• use competitive advantage to carve out market
  share when currency values change

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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.

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MANAGING OPERATING EXPOSURE

• C. Product Strategy
• exchange rate changes may alter
• 1. The timing of new product introductions,
• 2. Product deletion
• 3. Product innovations

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MANAGING OPERATING EXPOSURE

• III. Product Management Adjustments
• A. Input mix shop the world
• B. Shift production among plants
• C. Plant relocation (new)
• D. Raising productivity

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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