ECONOMIC

EXPOSURE
-Prepared by
SRIJAN SAXENA (4601)
RAGHAV BHATNAGAR (4624)
AKSHAY KHARBANDA (4627)
VINEETH VIJAYAN (4644)
 Economic Exposure-
Definition
• exposure to fluctuating exchange rates, affecting
company's earnings, cash flow and foreign
investments.”
• The risks faced by a company that does
business or holds investments abroad.
• includes changes in forex rates or the chance of
foreign countries defaulting on their debt.
• Measures change in value of business resulting from
changes in future operating cash flows caused by
unexpected exchange rate movement on future volumes,
prices and costs.
• Value of the firm:
C1 C2 Cn
V= + + ...+
(1 + r) (1 + r) (1 + r) n
• Factors determining the degree of economic exposure:
– Market structure;
– General business conditions
– Government policies.
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 unit’s cash flows
are correlated with variations in the
nominal exchange rate

The higher is b, the greater the

economic exposure of the
company.

4
Measuring Economic Exposure

∆CFt = a + β∆EXCH t + ut
where ΔCFt = CFt - CFt-1∆
CFt is the dollar value of total
parent cash flows in period t
ΔEXCHt = et - et-1
the change in the nominal exchange
rate during period t
u =a random error term
5
 Types of Economic
Exposure
 Operating
Exposure

 Transaction
Exposure
Operating Exposure
 Operating exposure measures any change in the
present value of a firm resulting from changes in
future operating cash flows caused by any
unexpected change in exchange rates.


1 +i f ,t
t =et (
e′ )
1 +ih ,t
et’= real rate (inflation adjusted)
et = nominal rate
if,,t = foreign inflation; ih,t = home inflation

 Arises because of currency fluctuations; can alter a

company’s future operating cash flows.
• Deals with
– The firm’s operations over the coming
months and years, and
– Its competitive position vis-à-vis other
firms.

• The most crucial and difficult component

to manage in foreign exchange (FX) risk.

• A firm faces operating exposure when:

– investment in servicing a market
subject to foreign competition
– in sourcing goods and inputs abroad.

• Measurement requires a longer-term

perspective, so that competitiveness
could be affected by exchange rate
exchanges.
 Case study
• Foster’s Group Limited
global producer and marketer
of alcoholic & non-alcoholic
beverages with core
operations in brewing
and wine.
Company preview…
• total operating revenue - AUD
5.2 billion
• 40 % of revenue generated
outside Australia
• 60 % - North America.
• Over 40 per cent of assets
located outside Australia, with
80 % in US
• A Market leader FGL holds
approximately 55 % share for
beer market.
 Modus operandi..

 operating exposure management

practices.

 primary analysis to explain

alternatives available to company
to manage its operating exposure.
• operating exposure -sensitivity of future cash flow
w.r.t exchange rate by sensitivity analysis.

• operating exposure depends on whether an

unexpected change in exchange rates causes

• unanticipated changes in sales

• sales prices
• operating costs

• these three variables will be used as variables in

the scenario for the sensitivity analysis
Base Case
1. company only has exposure to two
major foreign currencies euro and US
dollar.

2. 92 per cent of the company’s beer

sales are in Australia, 4 % in Europe
and another 4 % in US

3. For wine sales, 24 % of wine sales in

Australia, 16 per cent in Europe and
remaining 60 per cent is in the US

4. the overseas sales price is equivalent

to the domestic sales price.
 Results..
• It is shown that company
is sensitive to AUD
appreciation with the
company’s revenue more
sensitive than the cost.
• Without any adjustment
on sales volume and
foreign currency, sales
price the company
suffered an economic
loss of AUD 566.65
CONCLUSION

• demand is price sensitive.

• company will overcome change in
exchange rate if it
• increases its sales volume and
adjusts its sales price.
• The appropriate strategy to manage
the operating exposure will be to alter
product strategy, adjusting price
strategy and shifting production
among plants.
 MANAGING OPERATING
EXPOSURE
• Product differentiation & repositioning.
• Pricing Strategy
• Shifting production among plants
• Selecting Low-Cost Production Sites
• Flexible Sourcing Policy
• Diversification of the Market
• R&D Efforts and Product Differentiation
 Transaction Exposure
• Risk-exchange rate fluctuations will change the
value of a contract before it is settled.
– Also called transaction risk.
– It is the risk that for-ex rate changes will adversely
affect a cross-currency transaction before it is settled.
– Once a cross-currency contract has been agreed upon,
subsequent fluctuations in exchange rates can change
the value of that contract.
– A company that has agreed to but not yet settled a
cross-currency contract has transaction exposure.
– Greater the time, greater the risk
• For example,
– domestic company signs a contract with a foreign company to
ship 1,000 units of product to the foreign company
– Payment: 100 units of foreign currency, to be made in 3
months.
– current exchange rate: 1 unit domestic currency = 1 unit foreign
currency.
• The domestic company now has transaction exposure; value of the
contract is exposed to the risk of exchange rate fluctuations.
• New exchange rate: 1 unit domestic currency = 2 units foreign
currency
– New exchange rate remains constant till 3 months.
• Due to the devaluation foreign currency, the foreign company will
pay the domestic company only 50 units of domestic currency.
• The contract still stands at 100 units of foreign currency
– the domestic firm suffers a 50% loss in value.
 Minimizing Transaction Exposure

• Non-Hedging Techniques

•Hedging Techniques
 Non-Hedging Techniques
• Transferring exposure
– transferring the transaction exposure to another
company
• E.g.- A U.S. exporter could quote the sales price of its
product for sale in Germany in dollars, so the German
importer faces the transaction exposure
– demand immediate payment, so the spot rate
determines the dollar value of export.
• Netting transaction
– Unexpected exchange rate charges net out over
many different transactions
• Payments and receipts in multiple currencies
 Hedging Techniques
• Forward Market Hedge
• Money Market Hedge
– borrow (/lend) in foreign currency to hedge foreign
currency receivables (/payables),
• Options Market Hedge
– buy a foreign currency call (put) option to hedge
foreign currency payables (receivables)
• Hedging though Invoice Currency
– shift, share, or diversify exchange risk by
appropriately choosing the currency of invoice.
 Guarding against Economic
Exposure: Advantage China
 Exports surpluses are key drivers of
Chinese Economy growth.
 An upward pressure is put on China’s
currency when its dollar based revenues
inflows converted to Yuan.
 This upward pressure would strengthen
Yuan, making it less competitive at global
stage for trade
 Chinese central bank manages the value
of its currency.
 Till recently, trading of Yuan had been heavily
restricted by the government —
 Most international trade was priced in U.S. dollars
and settled in U.S. dollars.
 To offset- the central bank sells Yuan and buy
dollars.
 keeps the exchange rate stable
 China builds vast amounts of dollar reserves
 in 2005, it decided to peg Yuan to a basket of
currencies (USD, EUR, JPY and KRW) instead of
the sole USD in the past.
Since China adopted
the Managed float’
system yuan climbed
by 17% against USD.

grossly undervalued,
compare growth of
Chinese economy at
43% viz-a-viz US
economy at 10%
during the same
period.
 Currency Coalition
• euro (€) is the official currency of 16 of the 27
member states of the European Union (EU).
• BENIFITS
• removes cost of exchanging currency allowing to
enter in previously unprofitable trades.
• removes exchange rate risks.
• Companies that hedge against this risk will no
longer need to shoulder this additional cost.
 Currency Coalition
double edged sword
• recession of 2008 exposed fallacies of unified
currency system when countries don’t share same
industrial structure and economic health.
• Germany and France have already emerged out of
recessionary trend while Italy &others are forced to
crawl out at snail’s pace.
 spain
• Spain is being furthered into a
recessionary economy and is
close to breaking out into civil war.
• The economy used to benefit
• when market pressures forced down the local currency:
• “In 1992 and 1993 a series of devaluations got us out of
trouble.” Now Spain needs other adjustment mechanisms:
• SPAIN NEEDS TO!!!!!!!!@@@$$@#@
• lower wages to restore cost competitiveness to its firms
• flexible job market to speed the flow of workers from industries
such as construction to export firms that can generate the
revenues to service Spain’s debts.
 So what can Spain do?
• It needs to become more competitive — but it cannot have a devaluation,
because it is a euro country.
• Next alternative -wage cuts, which are desperately hard to achieve (and
create big problems for debtors.)

• <<<Final word>>>
• being a member of the Euro Zone doesn’t immunize countries against crisis.
• In Spain’s case (and Italy’s, Ireland’s, and Greece’s) the euro may well be
making things worse.
• by exposing themselves to a unified currency weaker economies risk their
primary avenue to pull out of recession or to adjust their budget deficits or
trade deficits etc.
•
 CONCLUSION
•At the microeconomic level,
economic exposure concerns
all firms the moment they are
exposed to global competition.

•individual firms through their

knowledge of hedging
techniques and proper planning
of operations can position
themselves

•China’s Currency Policy &

Undervaluation

•Volatility of Indian Markets

•Value Driven Production

Recommendations
 RBI should allow rupee to be traded
freely but should be prudent to keep it
in a narrow range (for eg. USD/INR
45-48).
 India could device a more transparent
method of managing its float, but
simultaneously allows the trading of
rupee, which would lead to less
transaction exposure for Indian
business houses.
 Internationalisation of exchanges
 Promoting Competition among certain
Industries.
 Common Currency Agreement
Sector Wise
Recommendations
IT Sector

• Reduce US dependence
• Diversify manufacturing
• Look for domestic
opportunities
• Move up the value chain
Textiles-

 Indian exporters should quickly move

up the learning curve in currency
hedging skills to protect budgeted
earnings.
 Exporters should also reduce
invoicing in dollar terms
Hospitality-
 Hospitalityindustry to offset a
negative impact of the rising rupee
should become more value driven in
terns of security and offerings and
other related services.
Automobile Sector-
 The Indian government has to back
this sector up for surge in exports.
 Sufficient investment in R& D to gain
a competitive advantage in the global
market.