CH 9: Management of Economic Exposure

Economic Exposure

Changes in exchange rates can affect not only firms that are directly engaged in international trade but also purely domestic firms.

Consider a Canadian bicycle manufacturer that sources and sells only in Canada. Since the firm’s product competes against imported bicycles, it is subject to foreign exchange exposure.

Exposure to currency risk can be properly measured by the sensitivities of 1) the future home currency values of the firms assets (and liabilities) and 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 exposure of operating cash flows depends on the effect of random exchange rate changes on the firms competitive position, which is not readily measurable.

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

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

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

Generally, a firm is subject to a high level of operating exposure when EITHER its cost or its price is sensitive to exchange rate changes. However, when BOTH are sensitive or insensitive to exchange rate changes, the firm has no major operating exposure.

Facing exchange rate changes, a firm may choose one of the following 3 pricing strategies:

• pass the cost shock fully to its selling prices

• Fully absorb the shock to keep its selling prices unaltered (no pass)

• Do some combination (partial pass)

3 Types of Exposure

Economic exposure

Economic Exposure - Exchange risk as applied to the firm’s competitive position

Any anticipated changes in the exchange rates would have already been discounted and reflected in the firm’s value.

Economic exposure can be defined as the extent to which a firm's value would be affected by unexpected changes in exchange rates.

Transaction Exposure

Transaction Exposure - Exchange rate risk as applied to the firm’s consolidated financial statements.

Defined as the sensitivity of “realized” domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes.

Arises from fixed-price contracting in a world of constantly changing exchange rates.

Translation Exposure

Translation Exposure - Exchange rate risk as applied to the firms’ consolidated financial statements.

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.

Involves many controversial issues.

How to Measure Economic Exposure

Economic exposure is the sensitivity of the future home currency value of the firm’s assets and liabilities and the firm’s operating cash flow to random changes in exchange rates.

There exist statistical measurements of sensitivity.

• Sensitivity of the future home currency values of the firm’s assets and liabilities to random changes in exchange rates.

• Sensitivity of the firms’ operating cash flows to random changes in exchange rates.

Operating exposure is the effect of random changes in exchange rates on the firm’s competitive position, which is not readily measurable. The extent to which the firms’ operating cash flows are affected by the exchange rate.

The exposure of retailers when a shortage in the shipping markets from Asia occurred had two components:

• The Competitive Effect - Difficulties and increased costs of shipping

• The Conversion Effect - Lower dollar prices of imports due to foreign currency exchange rate depreciation.

Determinants of Operating Exposure:

Recall that operating exposure cannot be readily determined from the firm’s 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 firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes.

Managing Operating Exposure:

The objective of managing operating exposure is to stabilize cash flows in the face of fluctuating exchange rates.

Selecting Low-Cost Production Sites

A firm may wish to diversify the location of its production sites to mitigate the effect of exchange rate movements.

Flexible Sourcing Policy

Sourcing applies to “Guest Workers.” (Hiring foreign crew)

Diversification of the market

Selling in multiple markets to take advantage of economies of scale and diversification of exchange rate risk.

R&D and Product Differentiation

Successful R&D that allows for

• Cost cutting

• Enhanced productivity

• Product differentiation

Successful product differentiation gives the firm less elastic demand, which may translate into less exchange rate risk.

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 firm’s cash flows in the near term. For example, the firm can lend or borrow foreign currencies on a long term basis, or the firm can use currency forward or options contracts and roll them over if necessary.

Financial Hedging involves the use of derivative securities such as currency swaps, futures, forwards, and currency options.

Summary

Exchange rate changes can affect a firm’s value by influencing its operating cash flows and the domestic currency value of assets and liabilities

Foreign currency exposure is classified as economic, transaction and translation exposure.

Exposure to currency risk can be measured by the coefficient in regressing the dollar value of the foreign asset on the exchange rate. Once the exposure is known, it can be hedged.

Operating exposure depends on the effect of random exchange rate changes on the firms future cash flows, not easily measured.

If the firm has an asset in a foreign country, its exposure to currency risk can be properly measured by the coefficient in regressing the dollar value of the foreign asset on the exchange rate. Once the magnitude of exposure is known, the firm can hedge the exposure simply by selling the exposure forward.

The firms’ operating exposure is determined by:

• Structure of the markets in which the firm sources its inputs and sells its products.

• The firm’s ability to mitigate the effects of exchange rate changes by adjusting markets, product mix and sourcing.

A firm can manage exposure by:

• Choosing low-cost production sites

• Maintaining flexible sourcing policies

• Diversification of the market

• Product differentiation

• Financial hedging

The objective of exposure management is to stabilize cash flow in the face of fluctuating exchange rates.

Apart from other operational and financial hedging methods, firms may let the cost of fluctuating exchange rates pass through to customers when firms have pricing power in the market place.