Measuring and

Managing Economic
Exposure
Chapter 10
Steps to the Creation of
an Economic Exposure
Step 1. Identifying the exposure
Strategy
Step 2. Define the risk
Step 3. List the operating exposures
Step 4. Measuring economic exposure
Step 5. Guidelines to create strategy
Step 6. Methods to manage risk

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 IDENTIFYING FOREIGN
EXCHANGE RISK AND ECONOMIC
I. EXPOSURE
FOREIGN EXCHANGE RISK: Step I.

A. Economic exposure defined:

focuses on the future impact of unexpected
currency fluctuations on firms value.
1 . The most important aspect of foreign
exchange risk management:
Incorporate expectations about the risk into all
basic decisions of the firm.

3
Step 2. Define the risk

2. Definition:
Economic exposure =
Transaction exposure +
Operating exposure:
arises because currency
fluctuations alter a companys
future revenues and expenses.

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FOREIGN EXCHANGE RISK
AND ECONOMIC EXPOSURE
B. Real Exchange Rates Changes and
Risk
Nominal v. real exchange rates:
real rate has been adjusted for
price changes.

Assume: no two nations have the same

annual rate of inflation.

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FOREIGN EXCHANGE RISK
AND ECONOMIC EXPOSURE
C. Implications
1. If nominal rates change with an
equal price change, no alteration to
cash flows.

*2. If real rates change, it causes

relative price changes and changes
in purchasing power.

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FOREIGN EXCHANGE RISK
AND ECONOMIC EXPOSURE

Operating Exposure begins:

the moment a firm starts to invest
in a market subject to foreign
competition
or
in sourcing goods or inputs
abroad
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Step 3 List the new risks

Operating exposure begins with

New product development
A distribution network
Brand name development
Marketing to foreign markets
Foreign supply contracts
Overseas production facilities

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Step 4. Measuring
economic exposure

To measure operating exposure

requires a longer-term
perspective.

i.e. Cost and price

competitiveness could be
affected by unexpected exchange
rate changes
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FOREIGN EXCHANGE RISK
AND ECONOMIC EXPOSURE

A decline in the real value of a

currency:
makes exports and import-competing
goods more competitive

An appreciating currency makes:

imports and export-competing goods
more competitive

10
FOREIGN EXCHANGE RISK
AND ECONOMIC EXPOSURE
During an appreciation of home
currencies:
Exporters face two choices:

keep prices constant (but lose sales)

or
adjust prices to foreign currency to
maintain market share (lose profits)
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FOREIGN EXCHANGE RISK AND
ECONOMIC EXPOSURE

3. SUMMARY
a. the economic impact of a
currency change depends on the offset
by the difference in inflation rates
or the change in real exchange rates.
b. It is the relative price changes
that ultimately determine a firms
long-run exposure.
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 Step 5. Guidelines to
create a strategy
I. ECONOMIC CONSEQUENCES
The impact on Operating Exposure of a
real rate change depends upon:
Pricing flexibility and
1. Price elasticity of demand 2.
Degree of product differentiation
3. The Ability to shift production and
the substitution of inputs
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If HC Appreciates

Pricing Flexibility is key

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If HC Appreciates

Can the firm maintain its profit

margins both at home and abroad?

If price elasticity of demand is low,

the more price flexibility a firm has.
i.e. Availability of good substitutes
The Ford Corp in Indonesia, 1997

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If HC Appreciates

Product Differentiation
price elasticity depends on degree
of differentiation

The greater the differentiation, the

more the firm can control its prices.

e.g. Daimler Chrysler Corp.

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If HC Appreciates

The Ability to Shift Production and

to source inputs from other
countries

e.g. Japanese car makers

(Toyota) in the late
1980s

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Step 6. Strategies to
manage economic
exposure
I. INTRODUCTION
Operating exposure
management requires long-term
operating adjustments and
the involvement of ALL
departments.
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MANAGING OPERATING
EXPOSURE
II. Marketing Strategy
A. Market Selection:
use competitive advantage
to carve out market share
when currency values
change

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MANAGING OPERATING
EXPOSURE
B. Pricing strategy: Expectations critical
1. If HC depreciates, exporter gains
competitive advantage by increasing
unit profitability or market share.
2. The higher price elasticity of
demand, the more currency risk
the firm faces by other product
substitution.

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MANAGING OPERATING
EXPOSURE

C. Product Strategy
exchange rate changes may alter
1. The timing of new product
introductions,
2. Product deletion
3. Product innovations

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MANAGING OPERATING
EXPOSURE
III. Product Management
Adjustments

A. Input mix shop the world

B. Shift production among
plants
C. Plant relocation (new)
D. Raising productivity
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MANAGING OPERATING
EXPOSURE
IV. Planning For Exchange-Rate
Changes
A. Develop contingency plans
with plausible scenarios
before the impact of a currency
change makes itself felt.
e.g. flexible mfg systems

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