2019-06-30

Management of Economic Exposure

Chapter 9

Copyright © 2018 by the McGraw-Hill Companies,

Inc. All rights reserved.

Economic Exposure
• Changes in exchange rates can affect not
only firms that are directly engaged in
international trade but also purely
domestic firms.
• If the domestic firm’s products compete
with imported goods, then their
competitive position is affected by the
strength or weakness of the local
currency.
9-2

1
 2019-06-30

Economic Exposure
• Consider a U.S. bicycle manufacturer who
sources, produces, and sells only in the U.S.
• Since the firm’s product competes against
imported bicycles, it is subject to foreign
exchange exposure.
• Their customers are comparing the cost and
features of the domestic bicycle against
Japanese, British, and Italian bicycles.

9-3

Economic Exposure
• Exchange rate risk is applied to the firm’s
competitive position.
• Any anticipated changes in the exchange rates
would already have been discounted and
reflected in the firm’s value.
• Economic exposure can be defined as the extent
to which the value of the firm would be affected
by unanticipated changes in exchange rates.

9-4

2
 2019-06-30

Exhibit 9.1: Exchange Rate Exposure of U.S. Industry

Portfolios

9-5

How to Measure Economic Exposure

• Economic exposure is the sensitivity of the
future home currency value of the firm’s assets
and liabilities and the firm’s operating cash flow
to random changes in exchange rates.
• There exist statistical measurements of
sensitivity.
– Sensitivity of the future home currency values of the
firm’s assets and liabilities to random changes in
exchange rates.
– Sensitivity of the firm’s operating cash flows to
random changes in exchange rates.

9-6

3
 2019-06-30

EXHIBIT 9.2
Channels of Economic Exposure

9-7

How to Measure Economic Exposure

• If a U.S. MNC were to run a regression on the dollar
value (P) of its British assets on the dollar-pound
exchange rate, S($/£), the regression would be of the
form:
P = a + b×S + e
Where
a is the regression constant.
e is the random error term with mean zero.
the regression coefficient b measures the sensitivity of the
dollar value of the assets (P) to the exchange rate, S.
9-8

4
 2019-06-30

How to Measure Economic Exposure

The exposure coefficient, b, is defined as
follows:
Cov(P,S)
b=
Var(S)

Where Cov(P,S) is the covariance between the

dollar value of the asset and the exchange rate,
and Var(S) is the variance of the exchange rate.

9-9

How to Measure Economic Exposure

• The exposure coefficient shows that there
are two sources of economic exposure:
1. The variance of the exchange rate.
2. The covariance between the dollar value of the
asset and exchange rate.

Cov(P,S)
b=
Var(S)
9-10

5
 2019-06-30

Example
• Suppose a U.S. firm has an asset in France
whose local currency price is random.
• For simplicity, suppose there are only three
states of the world and each state is equally
likely to occur.
• The future local currency price of this French
asset (P*) as well as the future exchange rate
(S) will be determined, depending on the
realized state of the world.

9-11

Example (continued)
State Probability P* S S×P*
Case 1
1 1/3 €980 $1.40/€ $1,372
2 1/3 €1,000 $1.50/€ $1,500
3 1/3 €1,070 $1.60/€ $1,712
Case 2
1 1/3 €1,000 $1.40/€ $1,400
2 1/3 €933 $1.50/€ $1,400
3 1/3 €875 $1.60/€ $1,400
Case 3
1 1/3 €1,000 $1.40/€ $1,400
2 1/3 €1,000 $1.50/€ $1,500
3 1/3 €1,000 $1.60/€ $1,600

9-12

6
 2019-06-30

Example (continued)
State Probability P* S S×P*
Case 1
1 1/3 €980 $1.40/€ $1,372
2 1/3 €1,000 $1.50/€ $1,500
3 1/3 €1,070 $1.60/€ $1,712

• In case one, the local currency price of the asset

and the exchange rate are positively correlated.
– This gives rise to substantial exchange rate risk.

9-13

Example (continued)
State Probability P* S S×P*
Case 2
1 1/3 €1,000 $1.40/€ $1,400
2 1/3 €933 $1.50/€ $1,400
3 1/3 €875 $1.60/€ $1,400

• In case two, the local currency price of the asset

and the exchange rate are negatively correlated.
– This ameliorates the exchange rate risk substantially
(completely in this example).

9-14

7
 2019-06-30

Example (continued)
State Probability P* S S×P*
Case 3
1 1/3 €1,000 $1.40/€ $1,400
2 1/3 €1,000 $1.50/€ $1,500
3 1/3 €1,000 $1.60/€ $1,600

• In case three, the local currency price of the

asset is fixed at €1,000.
– This “contractual” exposure can be completely
hedged using the methods we learned in Chapter 8.

9-15

Operating Exposure: Definition

• The effect of random changes in exchange
rates on the firm’s competitive position,
which is not readily measurable.
• A good definition of operating exposure is
the extent to which the firm’s operating
cash flows are affected by the exchange
rate.

9-16

8
 2019-06-30

An Illustration of Operating Exposure

• There was an enormous shortage in the
shipping market from Asia due to the
Asian currency crisis.
• This affected not only the shipping
companies, who enjoyed “boom times,”
but also retailers, who experienced
increased costs and delays.

9-17

An Illustration of Operating Exposure

• Note that the exposure for the retailers has
two components.
– The competitive effect:
• Difficulties and increased costs of shipping
– The conversion effect:
• Lower dollar prices of imports due to foreign
currency exchange rate depreciation.

9-18

9
 2019-06-30

Determinants of Operating Exposure

• Recall that operating exposure cannot be readily
determined from the firm’s accounting
statements as can transaction exposure.
• The firm’s operating exposure is determined by:
– The market structure of inputs and products; how
competitive or how monopolistic the markets facing
the firm are.
– The firm’s ability to adjust its markets, product mix,
and sourcing in response to exchange rate changes.

9-19

Managing Operating Exposure

• Selecting Low Cost Production Sites
• Flexible Sourcing Policy
• Diversification of the Market
• R&D and Product Differentiation
• Financial Hedging

9-20

10
 2019-06-30

Selecting Low Cost Production Sites

• A firm may wish to diversify the location of
its production sites to mitigate the effect of
exchange rate movements.
• For example, Honda built North American
factories in response to a strong yen, but
later found itself importing more cars from
Japan due to a weak yen and increased
exchange rate volatility.

9-21

Flexible Sourcing Policy

• Sourcing does not apply only to
components, but also to “guest workers.”
• For example, Japan Air Lines hired foreign
crews to remain competitive in
international routes in the face of a strong
yen, but later contemplated a reverse
strategy in the face of a weak yen and
rising domestic unemployment.

9-22

11
 2019-06-30

Diversification of the Market

• Selling in multiple markets to take
advantage of economies of scale and
diversification of exchange rate risk.

9-23

R&D and Product Differentiation

• Successful research and development
(R&D) allows for:
– Cost-cutting
– Enhanced productivity
– Product differentiation
• Successful product differentiation gives
the firm less elastic demand—which may
translate into less exchange rate risk.
9-24

12
 2019-06-30

Financial Hedging
• The goal is to stabilize the firm’s cash
flows in the near term.
• Financial hedging is distinct from
operational hedging.
• Financial hedging involves the use of
derivative securities such as currency
swaps, futures, forwards, and currency
options, among others.
9-25

EXHIBIT 9.12
Cash Flows Unhedged versus Hedged

9-26

13
 2019-06-30

Summary
• Exchange rate changes can systematically affect the value of
the firm by influencing the firm’s operating cash flows as well
as the domestic currency values of its assets and liabilities.
• It is conventional to classify foreign currency exposure into
three classes:
– Economic exposure can be defined as the extent to which the value of
the firm would be affected by unexpected changes in exchange rates.
– Transaction exposure is defined as the sensitivity of realized domestic
currency values of the firm’s contractual cash flows denominated in
foreign currencies to unexpected exchange rate changes.
– Translation exposure refers to the potential that the firm’s consolidated
financial statements can be affected by changes in exchange rates.

9-27

Summary (continued)
• If the firm has an asset in a foreign country, its exposure to
currency risk can be properly measured by the coefficient in
regressing the dollar value of the foreign asset on the
exchange rate.
– Once the magnitude of exposure is known, the firm can hedge the
exposure simply by selling the exposure forward.
• Unlike the exposure of assets and liabilities that are listed in
accounting statements, operating exposure depends on the
effect of random exchange rate changes on the firm’s future
cash flows, which are not readily measurable. Despite this
difficulty, it is important to properly manage operating
exposure since operating exposure may account for a larger
portion of the firm’s total exposure than contractual exposure.
9-28

14
 2019-06-30

Summary (concluding)
• A firm’s operating exposure is determined by
– (a) the structure of the markets in which the firm sources its inputs and
sells its products, and
– (b) the firm’s ability to mitigate the effect of exchange rate changes on
its competitive position by adjusting markets, product mix, and
sourcing.
• Since a firm is exposed to exchange risk mainly via the effect
of exchange rate changes on its competitive position, it is
important to consider exchange exposure management in the
context of the firm’s overall long-term strategic plan. The
objective of exposure management is to stabilize cash flow in
the face of fluctuating exchange rates.

9-29

Summary (concluded)
• To manage operating exposure, the firm can use various
strategies, such as
– (a) choosing low-cost production sites,
– (b) maintaining flexible sourcing policy,
– (c) diversification of the market,
– (d) product differentiation, and
– (e) financial hedging using currency options and forward contracts.

9-30

15