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THE UNIVERSITY OF HONG KONG

FACULTY OF BUSINESS AND ECONOMICS
FINA0105/2383A International Financial Management
FIRST SEMESTER, 2014-2015

Tutorial 3 Chapter 9 Management of Economic Exposure

(Continue with Tutorial Problem Set 2 Question 2, 4 & 5)

Question 1 (Asset Exposure)
Suppose that you hold a piece of land in the City of London that you may want to sell in one
year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if
the British economy booms in the future, the land will be worth 2,000 and one British pound
will be worth $1.40. If the British economy slows down, on the other hand, the land will be
worth less, i.e., 1,500, but the pound will be stronger, i.e., $1.50/. You feel that the British
economy will experience a boom with a 60% probability and a slow-down with a 40%
probability.

(a) Estimate your exposure b to the exchange risk.
(b) Compute the variance of the dollar value of your property that is attributable to the
exchange rate uncertainty.
(c) Discuss how you can hedge your exchange risk exposure and also examine the
consequences of hedging.


Question 2 (Asset Exposure)
Suppose you are a British venture capitalist holding a major stake in an e-commerce start-up
in Silicon Valley. As a British resident, you are concerned with the pound value of your U.S.
equity position. Assume that if the American economy booms in the future, your equity stake
will be worth $1,000,000, and the exchange rate will be $1.40/. If the American economy
experiences a recession, on the other hand, your American equity stake will be worth
$500,000, and the exchange rate will be $1.60/. You assess that the American economy will
experience a boom with a 70% probability and a recession with a 30% probability.

(a) Estimate your exposure to the exchange risk.
(b) Compute the variance of the pound value of your American equity position that is
attributable to the exchange rate uncertainty.
FINA0105/2383 International Financial Management Tutorial Problem Set 3

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(c) How would you hedge this exposure? If you hedge, what is the variance of the pound
value of the hedged position?






















FINA0105/2383 International Financial Management Tutorial Problem Set 3

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Chapter 9 Management of Economic Exposure
What is Economic Exposure?

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

If the domestic firms products compete with imported goods, then their
competitive position is affected by the strength or weakness of the local
currency.

Example: Consider a U.S. bicycle manufacturer who sources, produces, and
sells only in the U.S.

Since the firms product competes against imported bicycles, it is subject to
foreign exchange exposure.

Their customers are comparing the cost and features of the domestic bicycle
against Japanese, British, and Italian bicycles.


Exchange Rate Risk and Economic Exposure

Exchange rate risk is applied to the firms competitive position.

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

Economic exposure can be defined as the extent to which the value of the
firm would be affected by unanticipated changes in exchange rates.



FINA0105/2383 International Financial Management Tutorial Problem Set 3

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How to Economic Exposure?

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

There exist statistical measurements of sensitivity:

- Sensitivity of the future home currency values of the firms assets and
liabilities to random changes in exchange rates.

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


Example: 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:
P = a + b S + e
where

a is the regression constant
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.

The exposure coefficient, b, is defined as follows:



where Cov(P,S) is the covariance between the dollar value of the asset and the
exchange rate, and Var(S) is the variance of the exchange rate.
FINA0105/2383 International Financial Management Tutorial Problem Set 3

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Two Sources of Economic Exposure

The exposure coefficient shows that there are two sources of economic
exposure:

(1) The Variance of the exchange rate
(2) The Covariance between the dollar value of the asset and exchange rate