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Measuring and Managing Economic Exposure. Chapter 10. CHAPTER 10 MEASURING AND MANAGING ECONOMIC EXPOSURE. CHAPTER OVERVIEW I. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE II. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES III. IDENTIFYING ECONOMIC EXPOSURE

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chapter 10 measuring and managing economic exposure
CHAPTER 10MEASURING AND MANAGING ECONOMIC EXPOSURE

CHAPTER OVERVIEW

I. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

II. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES

III. IDENTIFYING ECONOMIC EXPOSURE

IV. CALCULATING ECONOMIC EXPOSURE

V. AN OPERATIONAL MEASURE OF EXCHANGE RISK

VI. MANAGING OPERATING EXPOSURE

steps to the creation of an economic exposure strategy
Steps to the Creation of an Economic Exposure Strategy

Step 1. Identify the exposure

Step 2. Define the risks

Step 3. Develop guidelines to create a strategy

Step 4. List the operating exposures

Step 5. Measure (calculate) the economic exposure

Step 6. Develop methods to manage risk

part i foreign exchange risk and economic exposure
PART IFOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

I. FOREIGN EXCHANGE RISK:

Step I. Identify the exposure

A. Economic exposure defined:

focuses on the future impact of unexpected currency fluctuations on firm’s value.

B. The most important aspect of foreign exchange risk management:

Incorporate expectations about the risk into all basic decisions of the firm.

foreign exchange risk and economic exposure
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

Step 2. Define the risks

C. Definition:

Economic exposure =Transaction exposure + Operating exposure

D. Operating Exposure:

arises because currency fluctuations alter a company’s future revenues and expenses.

foreign exchange risk and economic exposure1
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

E. 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.

foreign exchange risk and economic exposure2
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

F. 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.

part ii the economic consequences of exchange rate changes
PART IITHE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES

I. Operating Exposure begins:

the moment a firm starts to invest in a market subject to foreign competition

or in sourcing goods or inputs abroad

the economic consequences of exchange rate changes
THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES

Step 3. Develop guidelines to create a

strategy

II. ECONOMIC CONSEQUENCES

A. 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

the economic consequences of exchange rate changes1
THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES

B. During an appreciation of importer’s home currency:

Exporters face two choices:

1. keep prices constant (but lose sales)

or

2. adjust prices to foreign currency to maintain market share (lose profits)

if hc appreciates
If HC Appreciates

Pricing Flexibility is key

if hc appreciates1
If HC Appreciates

C. 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

if hc appreciates2
If HC Appreciates

D. 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.

if hc appreciates3
If HC Appreciates

E. The Ability to Shift Production and to source inputs from other countries

e.g. Japanese car makers (Toyota) in the late 1980’s who lost market share due to their inabililty to shift production

foreign exchange risk and economic exposure3
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

F. SUMMARY

1. the economic impact of a currency change depends on the offset by the difference in inflation rates or the change in real exchange rates.

2. It is the relative price changes that ultimately determine a firm’s long-run exposure.

part iii identifying economic exposure
PART IIIIDENTIFYING ECONOMIC EXPOSURE

Step 4. List the new risks

I. Operating exposure begins with

New product development

A distribution network

Brand name development

Marketing to foreign markets

Foreign supply contracts

Overseas production facilities

identifying economic exposure
IDENTIFYING ECONOMIC EXPOSURE

II. Key Questions to Identify Risk

A. Where is the company selling?

B. Who are the Company’s key competitors?

C. How sensitive is demand to price?

D. Where is the company producing?

E. Where are the company’s inputs coming from?

F. How are the company’s inputs and outputs priced?

part iv calculating economic exposure
PART IVCALCULATING ECONOMIC EXPOSURE

Step 5. Measure the 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

calculating economic exposure
CALCULATING 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

part v an operational measure of exchange risk
PART V.AN OPERATIONAL MEASURE OF EXCHANGE RISK

I. Operational Definition of Economic Risk

A. A company faces exchange risk to the extent that variations in the dollar value of the unit’s cash flows are correlated with variations in the nominal exchange rate.

an operational measure of exchange risk
AN OPERATIONAL MEASURE OF EXCHANGE RISK
  • Measure using Regression Analysis (e.g. Choi and Jiang 2009)
part vi managing operating exposure
PART VIMANAGING OPERATING EXPOSURE

I. INTRODUCTION

Step 6. Develop strategies to manage economic exposure

Operating exposure management requires long-term operating adjustments and the involvement of ALL departments.

managing operating exposure
MANAGING OPERATING EXPOSURE

II. Marketing Strategy

A. Market Selection:

use competitive advantage to carve out market share when currency values change

managing operating exposure1
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.

managing operating exposure2
MANAGING OPERATING EXPOSURE

C. Product Strategy

exchange rate changes may alter:

1. The timing of new product introductions,

2. Product deletion

3. Product innovations

managing operating exposure3
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

managing operating exposure4
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