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Hedging Economic Exposure 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)

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slide2

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

slide3

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.

slide4

“ 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!!

slide5

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

slide6

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

slide7

What can Pepsi do to Lower its currency exposure

Pepsi could attempt to better manage its cash flows

slide8

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

slide9

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

slide10

Increasing Canadian sales and lowering Canadian costs lowers exposure

EBIT

Old Structure

New Structure

$43

$40

$38

$35.20

E $/CD

.75

.80

slide11

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)
slide12

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)

slide13

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

slide14

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

slide15

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

slide16

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

slide17

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