Management of Economic Exposure

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• Management of Economic Exposure
• (chapter 12)

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Types of foreign exchange exposure/risk

• Translation exposure
• - Arises because reporting and consolidating
  financial statements requires conversion from
  foreign to local currency
• Transaction exposure
• - Arises because of changes in the domestic
  currency value of the firms outstanding
  obligations in foreign currency.
• Economic/Operating Exposure
• Arises because of changes in the firms
  competitive position

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Economic/Operating Exposure Definition

• The effect of random changes in exchange rates on
  the firms competitive position, future sales,
  costs, cash flows
• Two misconceptions about the source of economic
  exposure
• 1. Only firms that have foreign operations are
  exposed to the exchange rate changes
• 2. If all sales and/or purchases are
  denominated in domestic currency, then a firm is
  not exposed to the exchange rate changes
• Not easily measurable. However, there exist
  statistical measurements of operating exposure

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How to measure Economic Exposure

• If a U.S. MNC were to run a regression on the
  dollar value (P) of its British assets on the
  dollar pound exchange rate, S(/), the
  regression would be of the form

Where a is the regression constant and e is the
random error term with mean zero. The regression
coefficient b measures the sensitivity of the
dollar value of the assets (P) to the exchange
rate, S.
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An Illustration ofEconomic Exposure

• In the last three years the dollar depreciated
  sharply against the Euro, Yen and other major
  currencies
• Volkswagen GMBH. (VW) produces most of its cars
  in Germany but its biggest export market is the
  United States
• Note that the currency exposure for VW has two
  components
• - The Conversion Effect
• - The Competitive Effect

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Determinants of Operating Exposure

• Recall that operating exposure cannot be readily
  determined from the firms accounting statements
  as can transaction exposure
• The firms operating exposure is determined by
• - The market structure of inputs and products
  how competitive or how monopolistic the markets
  facing the firm are
• - The firms ability to adjust its markets,
  product mix, and sourcing in response to exchange
  rate changes
• Facing XR changes, a firm may choose one of
  these
• - pass the cost shock fully to its selling
  prices (complete XR pass-through)
• - full absorb the shock and keep the prices
  unchanged (no pass-through)
• - combination of the two

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Managing Operating Exposure

• Selecting Low Cost Production Sites
• Flexible Sourcing Policy
• A firm may wish to diversify the location of
  their production sites to mitigate the effect of
  exchange rate movements.
• Diversification of the Market
• Financial Hedging
• Financial Hedging is distinct from operational
  hedging
• Financial Hedging involves use of derivative
  securities such as currency swaps, futures,
  forwards, currency options

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Learning outcomes

• Discuss the three types of exchange rate
  exposure
• Define economic/operating exposure to exchange
  risk
• Explain how you can measure the
  economic/operating exposure
• Discuss the determinants of operating/economic
  exposure
• Discuss how a company can manage its operating
  exposure
• Briefly discuss Mercks five-step procedure for
  financial hedging (see the illustrated mini case
  on page 296)