Economic Exposure

INTERNATIONAL FINANCE

The extent to which the value of the firm in

terms of the domestic currency would be
affected by unanticipated changes in
exchange rates
Can

have a profound effect on the firms

competitive position
Affects domestic value of foreign operating cash
flows and foreign asset values

Chapter 9

9-1

Economic Exposure

Economic Exposure

Changes in exchange rates can affect firms

that are directly engaged in international
trade, but it also affects domestic firms
Consider a U.S. bicycle manufacturer who
sources and sells only in the U.S.
Since the firms product competes against
imported bicycles, it is subject to foreign
exchange exposure

Appreciation or depreciation of currencies

can have major effects
Depreciation

of U.S. dollar relative to yen could:

Weaken

competitive position of Japanese exporters

Enhance competitive position of U.S. exporters
Weaken competitive position of U.S. importers of
Japanese goods
Enhance competitive position of Japanese importers of
U.S. goods
9-2

How to Measure Economic Exposure

9-3

Channels of Economic Exposure

Sensitivity of the future home currency value

of the firms assets and liabilities and the
firms operating cash flow to random changes
in exchange rates.
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.
9-4

Asset exposure

Home currency
value of assets and
liabilities

Exchange
rate
fluctuations
Operating exposure

Firm
Value
Future operating
cash flows
9-5

How to Measure Economic Exposure

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:
P = a + bS + e

The exposure coefficient, b, is defined as follows:

b=

Cov(P,S)
Var(S)

Where

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.

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.
9-6

How to Measure
Economic Exposure

9-7

Example

The exposure coefficient shows that there are

two sources of economic exposure:
1.. the
t e variance
va a ce of
o the
t e exchange
e c a ge rate
ate and
a d
2. the covariance between the dollar value of the asset
and exchange rate

b=

Cov(P,S)
Var(S)

Suppose a U.S. firm has an asset in Britain whose

local currency price is random
For simplicity, suppose there are only three
states of the world and each state is equally
likely to occur
The future local currency price of this British
asset (P*) as well as the future exchange rate (S)
will be determined, depending on the realized
state of the world

9-8

Fixed Foreign Currency Value

Negatively Correlated

In case three, the local currency price of the

asset is fixed at 1,000

This

contractual exposure could be completely

hedged (futures, forwards, options, etc.)

State

9-9

Probability

P*

SP*

1/3

1,000

$1.40/

$1,400

1/3

1,000

$1.50/

$1,500

1/3

1,000

$1.60/

$1,600

In this case, the local currency price of the asset

and the exchange rate are negatively
correlated

State

Probability

P*

SP*

1/3

1,000

$1.40/

$1,400

1/3

933

$1.50/

$1,400

1/3

875

$1.60/

$1,400

Case 2

Case 3

This

helps to reduce the exchange rate risk (in this

example the risk is completely removed)

9-10

9-11

Positive Correlation
State

Asset Exposure

Probability

P*

SP*

1/3

980

$1.40/

$1,372

1/3

1,000

$1.50/

$1,500

1/3

1,070

$1.60/

$1,712

Case 1

Link between the home currency value of a

firms assets and liabilities and exchange rate
fluctuations
Assets

are usually readily identifiable

Can measure changes in asset value in foreign
currencies relative to exchange rate changes
History is not always a guide to the future

In this case, the local currency price of the asset

and the exchange rate are positively
correlated
This

gives rise to substantial exchange rate risk

change by large amounts

Values

9-12

9-13

Operating Exposure: Definition

Operating Exposure

The effect of random changes in exchange

rates on the firms competitive position, which
is not readily measurable
A good definition of operating exposure is
the extent to which the firms operating cash
flows are affected by the exchange rate

Note that operating exposure has two components:

Competitive Effect

A change in the firms competitive position in the market (cost,

price, etc.)

Conversion Effect

Change in domestic currency value of converted cash flows

Given same foreign currency receipts:
Domestic currency appreciation results in smaller domestic
currency receipts
Domestic currency depreciation results in larger domestic
currency receipts

9-14

Determinants of Operating Exposure

Operating exposure cannot be readily

determined from the firms accounting
statements as can transaction exposure

9-15

Operating Exposure Concerns

Price elasticity of product

Highly

price elastic

Unlikely

Operating exposure is determined

O
d
d by:
b
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

Inelastic

to easily pass through changes in exchange rate

prices

Exchange
Product

rates not as big a concern

differentiation

Correlation

to costs

If

costs and prices are similarly affected by exchange

rates, there may be a natural hedge

9-16

9-17

Managing Operating Exposure

Managing Operating Exposure

Selecting Low Cost Production Sites

firm may wish to diversify the location of their

production sites to mitigate the effect of exchange rate
movements.

Selling

in multiple markets to take advantage of

economies of scale and diversification of
exchange
h
rate risk
ik

Honda built North American factories in when the yyen was strong,
g,
but imported more cars from Japan when the yen weakened

Flexible Sourcing Policy

Sourcing

does not apply only to components, but also to

guest workers

Diversification of the Market

R&D and Product Differentiation

Cost

cutting; enhanced productivity; product

differentiation
Product differentiation = less elastic demand
which may translate into less exchange rate risk

Japan Air Lines hired foreign crews to remain competitive in

international routes in the face of a strong yen, but later
contemplated a reverse strategy in the face of a weakened yen
and rising domestic unemployment
9-18

9-19

Managing Operating Exposure

Financial Hedging
Goal

is to stabilize the firms cash flows in the

near term
Financial Hedging involves use of derivative
securities such as currency swaps, futures,
forwards, currency options, among others
Financial Hedging is generally not considered a
substitute for long-term operational hedging

INTERNATIONAL FINANCE
Chapter 9

9-20