Hedging Economic Exposure

1. Hedging Economic Exposure

2. Transaction Exposure vs. Economic Exposure Profits = e (Price – Unit Costs) Q Economic exposure refers to changes in the $ value of costs/revenues due to changes in demand (caused by exchange rate movements) Transaction exposure refers to changes in the $ value of costs/revenues due to exchange rate movements

3. Example: Exporting to Britain Suppose that GM is exporting automobiles to England. Exchange Rate ($/L) Revenues = e*P* Sales Price (L) If price, and sales are constant (i.e. independent of the exchange rate) then GM only faces transaction exposure. However, if price and sales are influenced by the exchange rate, the GM faces economic exposure as well.

4. “ The economic impact of currency exchange rates on us is complex because such things are often linked to real growth, inflation , interest rates, governmental actions” Revenues = e*P* Sales Cash flows might be functions of a lot of things that are associated with exchange rate changes!!

5. Example: Suppose that Pepsi has subsidiaries in both the US and Canada. Below is Pepsi’s income statement. Sales Canadian sales and costs are unaffected by exchange rate movements, but are subject to transaction exposure US $300 Canadian C$4 * .75 = $3 Total $303 Costs of Goods Sold US $50 US costs are independent of the Exchange rate, but US sales rise when the Canadian dollar strengthens (Canadian goods become more expensive) Canadian C$200 * .75 = $150 Total $200 Operating Expenses $30 US: Fixed $30 US: Variable Total $60 EBIT $43

6. If the Canadian Dollar Strengthens, both Costs and Sales are Affected. 1 CD = $.75 1 CD = $.80 Sales Sales US $300 US $310 Canadian C$4 * .75 = $3 Canadian C$4 *. 80 = $3.20 Total $303 Total $313.20 Costs of Goods Sold Costs of Goods Sold US $50 US $55 Canadian C$200 * .75 = $150 Canadian C$200 * . 80 = $160 Total $200 Total $215 Operating Expenses Operating Expenses $30 $30 US: Fixed US: Fixed $30 $33 US: Variable US: Variable Total $60 $63 EBIT $43 EBIT $35.20

7. What can Pepsi do to Lower its currency exposure Pepsi could attempt to better manage its cash flows

8. Example: Suppose that Pepsi has subsidiaries in both the US and Canada. Below is Pepsi’s income statement. Sales US $300 Canadian C$4 * .75 = $3 Total $303 Costs of Goods Sold If Pepsi could raise its Canadian Sales and lower its Canadian costs, it would be better insulated from exchange rate changes US $50 Canadian C$200 * .75 = $150 Total $200 Operating Expenses $30 US: Fixed $30 US: Variable Total $60 EBIT $43

9. Increasing Canadian sales and lowering Canadian costs lowers exposure 1 CD = $.75 1 CD = $.80 Sales Sales US $300 US $310 Canadian C$20 * .75 = $15 Canadian C$20 *. 80 = $16 Total $315 Total $326 Costs of Goods Sold Costs of Goods Sold US $140 US $145 Canadian C$100 * .75 = $75 Canadian C$100 * . 80 = $80 Total $215 Total $225 Operating Expenses Operating Expenses $30 $30 US: Fixed US: Fixed $30 $33 US: Variable US: Variable Total $60 $63 EBIT $40 EBIT $38

10. Increasing Canadian sales and lowering Canadian costs lowers exposure EBIT Old Structure New Structure $43 $40 $38 $35.20 E $/CD .75 .80

11. Searching for economic exposure • Economic exposure is much more general than transaction exposure (it can come from many sources). Therefore, it can be much more difficult to find! • Exchange rates change market competition • Exchange rates are correlated with Macroeconomic conditions • Exchange rates change the value of foreign currency cash flows (transaction exposure)

12. Changes in currency prices can have all kinds of economic impacts. A general way to estimate economic exposure would be as follows: Percentage change in the exchange rate ($/F) Percentage change in cash flows (measured in home currency)

13. Every 1% depreciation in the dollar relative to the British pound lowers cash flows from England by 3.35%

14. Suppose you have three different facilities … Plant C Plant A Overall, your cash flows are negatively related to the value of the Euro Plant B You first run a regression using consolidated income statements

15. Now, try isolating the exact location … Plant C Plant A Aha!!! Plant B is the culprit! (And they would’ve gotten away with it if it weren’t for those meddling kids!!!) Plant B Now, run a regression using individual plant income statements

16. Now, try isolating the specific income statement items … Sales Costs of Goods Sold Plant B Operating Expenses Ultimately, it looks like sales from plant B are the underlying currency problem Now, run a regression using individual plant income statements

17. Now, what do we do about it? • Pricing Policy: If sales drop when the Euro appreciates, then consider lowering prices during strong Euro periods to maintain market share • Cash flow matching: If sales (and hence, cash inflows) are dropping during periods with a weak dollar, try adjusting production locations so that your costs will drop at the same time. • Futures, Forwards, and Options