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Measuring and Managing

Economic Exposure
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
IV. CALCULATING ECONOMIC EXPOSURE
V. AN OPERATIONAL MEASURE OF
EXCHANGE RISK
VI. MANAGING OPERATING EXPOSURE
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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
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PART I
FOREIGN 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.

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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.
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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.

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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.

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PART II
THE 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

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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 9
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)
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If HC Appreciates

Pricing Flexibility is key

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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

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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.


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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

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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. 15
PART III
IDENTIFYING 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

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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?
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PART IV
CALCULATING 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

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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

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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.

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AN OPERATIONAL MEASURE OF
EXCHANGE RISK

B. Measure using Regression Analysis (e.g.


Choi and Jiang 2009)

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PART VI
MANAGING 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.

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MANAGING OPERATING EXPOSURE

II. Marketing Strategy


A. Market Selection:
use competitive advantage to carve
out market share when currency
values change

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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.
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MANAGING OPERATING EXPOSURE

C. Product Strategy
exchange rate changes may alter:
1. The timing of new product
introductions,
2. Product deletion
3. Product innovations

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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

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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

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