Topic 7

Economic Exposure
Text Book: Refer to Chapter 9
Subtitles
7.1 Measuring economic exposure
7.2 Managing economic exposure
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.

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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.

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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.

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

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7.1 Measuring 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.

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EXHIBIT 9.2
Channels of Economic Exposure

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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.
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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.
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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)
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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.

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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

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 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.

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 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).

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 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.

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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.

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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.

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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.

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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.

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

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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.

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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.

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

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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.

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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.

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EXHIBIT 9.12
Cash Flows Unhedged versus Hedged

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Financial Hedging Example: Case 1
• Financial hedging requires a knowledge of the extent to which the firm’s
operating cash flows are affected by the exchange rate.
• In the earlier example, consider Case 1.
• Here the foreign currency earnings are positively correlated with the
exchange rate changes.

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

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Case 1: Computation of
Beta
1. Computation of Means
P = 1/3 × (€1,372 + €1,500 + €1,712) = €1,528
S = 1/3 × ($1.40/€ + $1.50/€ + $1.60/€) = $1.50/€
2. Computation of Variance and Covariance
Var(S) = 1/3 × [($1.40/€ – $1.50/€)2 + ($1.50/€ – $1.50/€)2 + ($1.60/€ – $1.50/€)2] = 0.02/3
Cov(Pi S) = 1/3 ×[(€1,372 – €1,528)($1.40/€ – $1.50/€) + (€1,500 – €1,528)($1.50/€ – $1.50/€) +
(€1,712 – €1,528)($1.60/€ – $1.50/€)] = 34/3
3. Computation of the Exposure Coefficient
b = Cov(P,S)/Var(S) = (34/3)/(0.02/3) = €1,700

State Probability P* S S×P*

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

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Financial Hedging Example: Case 1
At T = 0, if we sell €1,700 forward at the 1-year forward rate,
F1($/€), that prevails at time zero. Suppose that F1($/€) = $1.48.
T=0 T=1
P* S ($/€) F1($/€)
1

€980 × $1.40/€ =$1,372 Sell

1 Buy €720 at $1.40/€1
€1,700×$1.50/€1=$2,550
=$1,008
net cash flow =$1,542
€1,00 × $1.50/€ =$1,500 Sell
0 1 Buy €700 at $1.50/€1
€1,700×$1.50/€1=$2,550
=$1,050
net cash flow =$1,500

€1,07 × $1.60/€ =$1,712 Sell

0 1 Buy €630 at $1.60/€1
€1,700×$1.50/€1=$2,550
=$1,008
net cash flow =$1,542
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Financial Hedging Example: Case 2
• In Case 2, we have a built-in hedge, requiring no
derivatives.
• You can also calculate b as zero using the same
previous methodology.

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

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Financial Hedging Example: Case 2
At T = 0, if we sell b = €0 forward at the 1-year forward rate that
prevails(suppose
at time zero
that F1($/€) = $1.50).

T=0 T=1
P* S1($/€)

€1,000 × $1.40/€1 = $1,400

€933 × $1.50/€1 = $1,400

€875 × $1.60/€1 = $1,400

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Financial Hedging Example: Case 3
• Financial hedging requires a knowledge of the extent to which the firm’s
operating cash flows are affected by the exchange rate.
• In an earlier example from Chapter 8, we showed how to hedge case three:
simply sell b = €1,000 forward or use a money market hedge.

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

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Financial Hedging Example: Case 3
At T = 0, sell €1,000 forward at the 1-year forward rate
F1($/€) that prevails at time zero. Suppose that F1($/€) =
$1.50.
T=0 T=1
P* S1($/€) P* F1($/€)
€1,00 × $1.40/€ =$1,400 €1,00 × $1.50/€ =$1,500
0 1 0 1

€1,00 × $1.50/€ =$1,500 €1,00 × $1.50/€ =$1,500

0 1 0 1

€1,00 × $1.60/€ =$1,600 €1,00 × $1.50/€ =$1,500

0 1 0 1
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