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ECONOMIC EXPOSURE. Agenda. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES IDENTIFYING ECONOMIC EXPOSURE. CONCEPT OF FOREIGN EXCHANGE EXPOSURE. Economic exposure focuses on the impact of currency fluctuations on the firm’s value.

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Economic exposure

ECONOMIC EXPOSURE

Presenter: Van Phan


Agenda
Agenda

  • FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

  • THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES

  • IDENTIFYING ECONOMIC EXPOSURE

Presenter: Van Phan


CONCEPT OF FOREIGN EXCHANGE EXPOSURE

Economic exposure focuses on the impact of currency fluctuations on the firm’s value.

  • Expectations about fluctuations must be incorporated in all basic decisions of the firm.

  • Definitions:

    • Accounting exposure: impact on firm’s balance sheet

    • Economic exposure

      • Cash Flow exposure

      • Net worth exposure

Presenter: Van Phan


Definition
Definition

  • Economic Exposure: The risk that exchange rate changes may affect the present value of future income streams.

Presenter: Van Phan


Case 1: No Deviation From PPP

  • An example of a U.S corporation’s British Subsidiary

  • Assumption: PPP holds

    • Nominal ER=  - * = S

    • Domestic inflation less foreign inflation should equal the change in the spot rate.

    • Implies that the higher inflation country should see its currency depreciate.= depreciation of £ is the result of higher inflation in UK than in U.S

Presenter: Van Phan


No Deviation From PPP

  • £ price of the product will rise in accordance with British inflation

  • Results

    • $price

    • $ AC

    • $ margin No change

    • Volume

    • Profit

Presenter: Van Phan


Case 2: Real ER changes and self-contained subsidiary-Price-Taker

  • Perfectly competitive market

  • British operation services the local market and undertakes all production locally

  • £ depreciates in real term

    • £ Price: not change: price taker

    • $ Price: change

    • $ Costs: change

    • $ Profit margin: Decline in proportion of ER change

Presenter: Van Phan


Real ER changes and self-contained subsidiary-Price-Taker subsidiary-Price-Taker

$

MC

AC

MR

Po

MR’

P1

Co

C1

Q0

Quantity

Presenter: Van Phan


Real er changes and self contained subsidiary price maker
Real ER changes and self-contained subsidiary-Price-Maker subsidiary-Price-Taker

  • The result is the same: Why

    • £ denominated demand curve: no change with the depreciation of £

    • $ equivalent demand curse shift down

      • £ Price: not change: no change in D

      • $ Price: change

      • $ Costs: change

      • $ Profit margin: Decline in proportion of ER change

Presenter: Van Phan


Case 3 real er and a world output market
Case 3: Real ER and a World Output Market subsidiary-Price-Taker

  • Assumption:

    • British subsidiary functions in a world market for output

    • The world price is determined in $ (MR=MR’)

  • Results of £ depreciation

    • Change the cost structure because of the local inputs

    • Increase the production

      = Increase profit

Presenter: Van Phan


Real er and a world output market
Real ER and a World Output Market subsidiary-Price-Taker

MC’

$

MC

AC

AC’

MR=MR’

Po

Co

C1

Quantity

Q0

Q1

Presenter: Van Phan


Case 4 real er and a world input market
Case 4: Real ER and a World Input Market subsidiary-Price-Taker

  • Assumption:

    • Output is priced in £

    • Input is priced in $ (MR=MR’)

  • Results of £ depreciation

    • Shift the $MR down

    • Cost function does not shift down

      = cut production to reduce costs= profit declines

Presenter: Van Phan


Case 5 real er and a world input output market
Case 5: Real ER and a World Input & Output Market subsidiary-Price-Taker

  • Assumption

    • Competing in a world of output

    • Producing the output with factors supplied in a world input market

  • Results of £ depreciation

    • No shift the $MR

    • No shift the cost function= no economic exposure

Presenter: Van Phan


Conclusion local currency depreciation
Conclusion subsidiary-Price-TakerLocal Currency Depreciation

Presenter: Van Phan


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