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Chap 9: Management of Economic Exposure - Coggle Diagram
Chap 9: Management of Economic
Exposure
How to Measure Economic Exposure
Changes in exchange rates can affect
firms that are directly engaged in international trade
the operating cash flows of a firm by altering its competitive position,
purely domestic firms.
dollar (home currency) values of the firm’s assets and liabilities
the value of the firm by influencing its operating cash flows
the domestic currency values of its assets and liabilities
Currency risk
Currency risk is precisely measured by:
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
represents random changes in exchange rates
Measuring Asset Exposure
P = a + b×S + e
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 asset (P) to the exchange rate (S)
The exposure coefficient, b, is defined:
b = Cov(P,S)/Var(S)
Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate
Var(S) is the variance of the exchange rate
Hedging Asset Exposure
Once the magnitude of the exposure is known, the firm can hedge the exposure by simply selling the exposure forward
We can decompose the variability of the dollar value of the asset, Var(P), into two separate components: exchange rate-related and residual
Operating Exposure
is the extent to which the firm’s operating cash flows will be affected by random changes in the exchange rates
Many managers do not fully understand the effect of volatile exchange rates on operating cash flows
In many cases, operating exposure may account for a larger portion of the firm’s total exposure than contractual exposure
Illustration of Operating Exposure
Consider the possible effect of a depreciation of the pound on the projected dollar operating cash flow of Albion Computers
The dollar operating cash flow may change following a pound depreciation due to:
Competitive effect
Conversion effect
Varying degree of realism:
CASE 1: No variables change, except the price of the imported input.
CASE 2: The selling price as well as the price of the imported input changes, with no other changes.
CASE 3: All the variables change.
Determinants of Operating Exposure
Operating exposure cannot be readily determined from the firm’s accounting statements, unlike transaction exposure
A firm’s operating exposure is determined by:
The structure of the markets in which the firm sources its inputs, such as labor and materials, and selling its products
The firm’s ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing
A firm is usually subject to high degrees of operating exposure when either its cost or its price is sensitive to exchange rate chages
When both the cost and the price are sensitive or insensitive to exchange rate changes, the firm has no major operating exposure
The extent to which a firm is subject to operating exposure depends on the firm’s ability to stabilize cash flows in the face of exchange rate changes
Facing exchange rate changes, a firm may choose one of the following three pricing strategies:
pass the cost shock fully to its selling prices (complete pass-through)
fully absorb the shock to keep its selling prices unaltered (no pass-through)
do some combination of the two strategies described above (partial pass-through)
Managing Operating Exposure
Objective: is to stabilize cash flows in the fact of fluctuating exchange rates
Firms may use the following strategies for managing operating exposure:
Diversification of the market
is another way to managing exchange exposure
Note that expansion into a new business should be justified on is own right, not solely as a solution to currency exposure
Flexible sourcing policy
Even if a firm has manufacturing facilities only in the domestic country, it can substantially lessen the effect of exchange rate changes by sourcing from where input costs are low
is a strategy for managing operating
exposure that involves sourcing from areas where input costs are low
Product differentiation and R&D efforts
Investment in research and development (R&D) can allow the firm to maintain and strengthen its competitive position in the face of adverse exchange rate movements
Successful R&D allows the firm to do the following:
Cut costs and enhance productivity
Introduce new and unique products for which competitors offer no close substitutes
Selecting low-cost production sites
When the domestic currency is strong or expected to become strong, a firm may choose to locate production facilities in a foreign country where costs are low
Low costs may be due to either the undervalued currency, or underpriced factors of production
The firm may choose to establish and maintain production facilities in multiple countries to deal with the effect of exchange rate changes
Financial hedging
can be used to stabilize the firm’s cash
flows
refers to hedging exchange risk exposure using financial contracts such as currency forward and options contracts
If operational hedges, which involve redeployment of resources, are costly or impractical, financial contracts can provide the firm with a flexible and economical way of dealing with exchange exposure
