Exchange Rate Exposure II:

Economic Exposure
Instructor: Dr Kelvin Tan
Reading: Eun Resnick Chapter 9

Types of Exchange Rate Exposure: A Revisit

Transaction Exposure A short-term exposure that is
due to transactions having to be settled in a foreign
currency
Translation Exposure arises due to the need to
consolidate financial statements of foreign operations
into home currency
Economic/Operating Exposure the impact of
currency fluctuations on a firms future cash flows.
Economic Exposure is a long term exposure. This makes it hard to hedge against
but it is very important since it affects firm value.
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Lecture Outline
Introduction to Economic (or Operating) Exposure
Why and how does it arise?
How to measure economic exposure?
Methods of hedging economic exposure?
Real World Examples

USD/AUD (Jan 07 Apr 12)

Source: http://www.google.com/finance?q=AUDUSD accessed on the 19th April 2012

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Australias AAA yield advantage

Westpac 2013

What is Economic Exposure?

Economic/Operating Exposure the impact of
currency fluctuations on a firms future cash flows.
Fluctuations in future cash flow influences the firms present value

It is the extent of sensitivity of the Market Value of a

firm (or a portfolio of securities) to exchange rate
T
movements.
CFt
MVt =
t
t = 0 (1 + i )
Cash flows (CFt) can be disentangled into its various
constituents that can be denominated in several
currencies.
T
T CF
CF$,t
Yen,t S $ Yen,t

MVt =
+
t
t
(1 + iYen,t )
t = 0 (1 + iS ,t )
t =0

More on Economic Exposure

Cash flows can be further decomposed into:
Sales/Revenues = Price * Quantity
Costs = Fixed + Variable * Number of goods produced
Sales and Revenue are cash inflows, Costs are cash outflows.

Misconceptions about the source of economic exposure:

Only firms that have foreign operations are exposed
Firms that denominate all transactions in the home currency
are NOT exposed
The firms are still within the open market and are still competing against foreign sellers.

It is possible to have operating exposure even without a

change in the nominal exchange rate.
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The Source of Economic Exposure

Economic exposure arises when the value of the
firm is affected by changes in the Real exchange
rate. Exchange rates affect the value of the firm
through their impact on
Revenues
Costs and
Competitive position

Note that if a change in the exchange rate merely

reflects differential rates of inflation between
countries, then relative prices would not change
and the value of the firm would be unaffected
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More on Economic Exposure

This exposure can be denoted as

MV
S$ A FC

where

MVt =
t =0

CF$,t

(1 + i )

S ,t

+
t =0

CFYen,t S $ Yen,t

(1 + i )

Yen,t

It measures the marginal impact on firm value by a

change in the ($A/FC) exchange rate.
This can also be written as
Total un exp ected change in Op. CF at T , in HC
Op. Exposure =
Un exp ected change in ST

An Example
Albion Computers, a US firm, has a British subsidiary
that manufactures and sells PCs in the UK.
Main input is Intel processors, priced in dollars
($512/unit) Variable costs.
All other costs are in British pounds (Fixed
cost=4M, Variable cost= 330/unit).
Depreciation = 1M
S0 = $1.60/
Expects to sell 50,000 PCs this year at 1,000 each.
Tax rate=50%
What are the operating cash flows in pounds and dollars?
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Albion Computers Base Case

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Albion Computers Case 1

Assumes only the

price of imported
input changes.
(Albion does not
pass-through any
of this higher cost.
Thus profit
margins fall.)

As the depreciates, the input cost of imported Intel chips

increases resulting in lower profits, and the operating12
cash flows are worth fewer $s.

Albion Computers Case 2

Assumes price
of imported
input AND
selling price
increase.

Assumes Albion will sell the same number of units after

passing on all (and then some) of the higher cost. Thus,
assumes demand highly inelastic.

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Albion Computers Case 3

Assumes selling
price and local
costs increase by
8% (local inflation
rate). Also assumes
demand is elastic.
Sales fall by 10,000
units at the higher
selling price.

Input costs have gone up, unit sales have fallen, and
the operating cash flows are worth fewer $s.

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Albion Computers

x2.85

[1-(1+0.15)^(-4)]/(0.15) = 2.85 annuity factor for 4 years at 15%

Case 1: Demand elastic. To maintain market share, absorb all cost increases
(no pass-through). Profit margins fall.
Case 2: Demand inelastic, pass-through all cost increases, maintain/improve
margins.
Case 3: Demand elastic, absorb some of cost increase, lose both market
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share and profit margins.

Impact of Economic Exposure

A strong dollar can make imports look cheap to
Australian purchasers.
Can bring new competition.

Exchange rates can affect the price a firm pays for

inputs imported from foreign countries.
Raise prices (lower demand) or earn lower profits?

Exchange rates can affect the foreign demand for a

firms product.
Weak dollar can make Australian exports attractive.
Increase in foreign demand can also increase Australian
prices if production doesnt adjust fast enough.
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A Real World Example Honda Motors

Honda used to manufacture all its automobiles in Japan
and ship them to the U.S.
U.S. demand declined with yen appreciation
1,250,000
In January 1993, exchange rate was about 125 /$. = $10,000
By April, it fell to 113-114 /$ range = $11,062
NY Times says that Japanese manufacturers would have to
take stern measures to reduce their costs and improve their
efficiency.
June 1993 dollar fell to about 110 /$ = $11,364
End of summer, 100 /$ = $12,500
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A Real World Example Honda Motors

In July, Japanese auto exports 14% below

previous years level.

Honda posted a 55% drop in pre-tax profit for quarter

ending June 30, 1993.

The New York Times reported Japanese

manufacturers were shifting production to U.S.
Honda has built manufacturing plants in the U.S. to produce
automobiles for sale there.

What are the benefits?

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Economic Exposure Important

Firms cannot just focus on transactions risk
alone.
For example, by hedging their foreign currency
payables or receivables.

Firms must also attempt to determine how all

their cash flows will be affected by possible
exchange rate movements.

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Recognising Economic Exposure

Another example:
Aspen Skiing Company owns and operates ski resorts in
Colorado
Uses only American labor and materials (USD)
Nonetheless, hurt by a strong dollar that made American
skiers opt for the French Alps or the Canadian Rockies, and
foreign skiers stay at home.

So, even a domestic firm with zero transaction exposure

to exchange rates can be vulnerable to exchange rate
risk.
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Recognising Economic Exposure

To some extent, exposure of foreign firms to exchange
rates may be larger or smaller than domestic firms
e.g., A Swedish firm in London with both costs and
revenues denominated in pounds may not have much
exposure.
On the other hand, a British firm with all sales and costs
in the UK could have high exposure simply because it
main competitors are foreign.

Dominguez and Tesar (2001) found that firms that operate in the
traded sector had similar exposures to firms in the non-traded
sector. They find substantial heterogeneity in exposure across
firms and even in firms within the same industry.

Higher international competition results in more exposure.

Traded sector refers to anything which can be traded (goods. eg. pens) whereas
non-traded sector refers to things which can't (eg construction industry)

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Recognising Economic Exposure

Where is the company selling? [domestic v. foreign]
Who are the key competitors? [domestic v. foreign]
How sensitive is demand to price?
Where is the company producing? [domestic v. foreign]
Where are the companys inputs coming from?
[domestic v. foreign]
How are the companys inputs or outputs priced?
[world price v. domestic market]
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Conduits for Economic Exposure

Impact of Exposure can be DIRECT or INDIRECT
For example, AUD 1/
HC=AUD; FC=

HC strengthens

HC weakens

e.g., AUD 0.8/

e.g., AUD 1.3/

Sales abroad (e.g, sell @ 10) Unfavourable

Source abroad(e.g, cost @ 1) Favourable
Profits abroad
Unfavourable

Favourable
Unfavourable
Favourable

Direct Exposure

Indirect Exposure
Supplier sources abroad
Favourable
Competitor sources abroad
Unfavourable

Unfavourable
Favourable
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More on Economic Exposure

Customer Reactions: Real exchange rate changes will
often be associated with changes in real demand
Competitor and Supplier reactions
The ability to shift production and sourcing

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Consider All Effects

In sum, the full impact of foreign exchange changes on
cash flows
Depends not only on first order (most important)
price effects
But also on indirect effects such as responses of
customers, competitors, suppliers, their competitors
and suppliers, and so on.
The more flexibility the firm has in terms of pricing
its product and sourcing its inputs from wherever in
the world they are cheapest, will significantly
reduce any adverse impact of exchange rate
changes.
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Estimating Economic Exposure

Audits/Scenario Analysis: Qualitative examination of the
separate elements of a firms operating cash flow and
anticipating its sensitivity to real exchange rate changes.
Statistical Approach: Regress changes in firm value on
changes in exchange rates to obtain a quantitative
assessment of sensitivity.
Presumption is that changes in the value of a firms public securities
measures the effect of exchange rate changes. (measure of aggregate
exposure)

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Managing Economic Exposure

Use of Marketing Strategies
Market Selection
Pricing Strategy/Product strategy
Promotional Strategy

Use of Production Management

Input mix
Plant Location & Shifting production among plants
Raising Productivity (i.e. lowering costs)

Financial Hedging techniques may also be used, but

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Example: European Motors

The weak dollar/strong Euro hurts European exporters
Converting dollar profits back to Euro
Smaller profits on sales (exchange rate pass-through is low
due to highly competitive market environment in their largest
market: US)

For example, to overcome this problem, German auto

makers now sell some high-end models in the U.S. for
far less than they charge in Europe
E.g, Porsches Carrera GT sells for the equivalent of 338,000
euro in the US and 453,000 euro in Germany.

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Natural Hedges
Toyota has insulated itself to some extent against dollar
fluctuations
It builds 60% of the cars sold in North America in North
America

Michelin, the worlds largest tire maker, has 40% of its

annual sales in North America.
Most of the imported raw materials used by Michelin are also
priced in dollars

BMW has created natural hedges by producing cars in

America and Britain
It opened a factory in S. Carolina in 1994 and produced
160,000 vehicles there in 2003.
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Transactional Hedges
Unlike BMW, Porsche makes most of its cars in
Germany, so its costs are mostly in euros. Yet a large
chunk of revenues come from sales of sports cars in
America
Unlike BMW, Porsche has no natural hedge
Thus, Porsche uses financial hedging
Porsche says they are 100% hedged against the dollar
through 2007

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(Lack of) Transactional Hedges

Volkswagen attributed most of its 1.2 Billion euro
losses in 2003 to currency swings it had not hedged
against.
This had a real effect as it announced plans to cut 5000
jobs.
It has since stepped up its hedging to 70% of its
exposure. (NY Times Jan. 17, 2004 & Mar. 9, 2004)

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Chinas Textile Industry (WSJ 19/4/04)

During the Asian crisis, Chinas neighbors saw
their currencies plummet
In 1998, an Indonesian cotton shirt suddenly
became 80% cheaper
Chinese garment makers began to turn out
expensive sportswear, for example, rather than
cheap cotton shirts. They began to purchase more
inputs from Southeast Asia to lower costs.
China emerged from the turbulence of 1997 and
1998 a tougher competitor than ever.
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Pass-through = 1 if firm can pass-through all exchange rate changes.

Pass-through = 0 if pass-through none.
Firms with pricing power (inelastic demand) will pass-through the33most.

Exchange Rate Changes and Profit Margins: The

Case of Japanese Exporters

Klitgaard (April 1999), FRBNY, Economic

Policy Review
Examines statistically how Japanese exporters
respond to the conflicting objectives of
(1 ) maintaining stable profit margins vs.
(2) stable export sales
in the face of fluctuations in the value of the yen.

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Exchange Rate Changes and Profit Margins

Foreign customers do observe exchange-rate driven changes in
prices, but the Japanese firms moderate the extent of these changes
by altering their profit margins.

60%

40%

20%

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Exchange Rate Changes and Profit Margins

Possible responses to yen appreciation:
Maintain foreign price at pre-appreciation level/lower yen
price lower profit margin
USD10
T=0:USD1=Yen125USD10*125=Yen1250
T=1:USD1=Yen100USD10*100=Yen1000

Raise foreign price/maintain yen price maintain profit

margin at pre-appreciation level
From USD10 to USD12.5
T=0:USD1=Yen125USD10*125=Yen1250
T=1:USD1=Yen100USD12.5*100=Yen1250

Combination of the two: Raise foreign price, but not enough

to maintain same yen profit margin.

This combination best describes Japanese exporter pricing behavior.

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Exchange Rate Changes and Profit Margins

Why would this make sense?
A firm that has found its profit-maximizing price in
each market will attempt to keep its goods at that
price. (Cares about maintaining market share.)
Thus, firms are inclined to absorb currency swings
into their profit margins to stabilize prices seen by
foreign customers.

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