CH 9: Management of Economic Exposure

Exposure to currency risk can be properly measured by the sensitivities of 3 things

1) The future home currency values of the firms assets (and liabilities)

2) The firms operating cash flows to random changes in exchange rates

Operating exposure

The extent to which the firms operating cash flows would be affected by random changes in exchange rates

The dollar operating cash flow may change following a pound depreciation due to:

1) The competitive effect - A pound depreciation may affect operating cash flow in pounds by altering the firms competitive position in the marketplace

2) the conversion effect - A given operating cash flow in pounds will be converted into a lower dollar amount after the pound depreciation

when both price and cost of a firm are sensitive or insensitive to exchange rate changes, the firm has

NO major operating exposure

A firm is subject to a high level of operating exposure when

EITHER its cost or its price is sensitive to exchange rate changes

When a firm faces exchange rate changes, they may choose out of 3 pricing strategies

1) Pass the cost shock fully to its selling prices

2) Fully absorb the shock to keep its selling prices unaltered (No pass)

3) Do some combination (partial pass)

3 types of Foreign currency Exposure

1) Economic

2) Transaction

3) Translation

Economic exposure

The extent to which a firms value would be affected by unexpected changes in exchange rates. Any anticipated changes in the exchange rates would have already been discounts and reflected in firms value.

Transaction Exposure

Exchange rate risk as applied to the firms consolidated financial statements. The sensitivity of “realized” domestic currency values of the firms contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Arises from fixed-pricing contracting in a world of constantly changing exchange rates.

Translation Exposure

Exchange rate risk as applied to the firms consolidated financial statements. Consolidation involves the translation of subsidiaries financial statements from local currencies to home currency.

Operating Exposure

The effect of random changes in exchange rates on the firms competitive position, not readily measurable.

A firms operating exposure is determined by

1) The market structure of inputs and products: How competitive or how monopolistic the markets facing the firm are

2) the firms ability to adjust its markets, product mix, and sourcing in response to exchange rate changes.

what is the objective of managing operating exposure

Stabilize cash flows in the face of fluctuating exchange rates.

How can you manage operating exposure

1) Selecting low-cost production Sites

2) Flexible Sourcing Policy

3) Diversification of the market

4) R&D and Product differentiation

5) Financial Hedging

Financial Hedging

Refers to hedging exchange risk exposure using financial contracts such as currency forward and options contracts. The goal is to stabilize the firms cash flows in the near term. Involves the use of derivative securities such as currency swaps, futures, forwards, and currency options.

Firms may let the cost of fluctuating exchange rates pass through to customers when

Firms have pricing power in the market place