Management of Economic Exposure

 Three Types of Exposure

 How to Measure Economic Exposure

 Operating Exposure: Definition

 An Illustration of Operating Exposure

 Determinants of Operating Exposure

 Managing Operating Exposure

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 Three Types of Exposure
 Economic Exposure
• Exchange rate risk as applied to the
firm’s competitive position.
 Transaction Exposure

• Exchange rate risk as applied to the

firm’s home currency cash flows.
 Translation Exposure

• Exchange rate risk as applied to the

firm’s consolidated financial statements.
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 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.

 Asset Exposure + Operating Exposure

 There exist statistical measurements of

sensitivity.
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 How to Measure
Economic Exposure
 If a U.S. MNC owns an assets in UK, the
exposure can be measured by the coefficient
b in regressing the dollar value (P) of its
British assets on the dollar pound exchange
rate, S($/£),
P  a  b S  e
Where a is the regression constant and 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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 Suppose that a US firm has an asset in Britain
whose local currency price is random. There are
three possible state.
 Case 1

State Prob. Price Rate Price$ Parameters

1 0.33 980 1.40$ 1372 Cov(PS)=34/3
2 0.33 1000 1.50$ 1500 Var(S)=0.02/3
3 0.33 1070 1.60$ 1712 b=1700 GBP
Mean 1.50$ 1528

1700 GBP represents the sensitivity of the

future dollar value of the British assets to
random change in exchange rate
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 Case 2

State Prob. Price Rate Price $ Parameters

1 0.33 1000 1.40$ 1400 Cov(PS)=0
2 0.33 933 1.50$ 1400 Var(S)=0.02/3
3 0.33 875 1.60$ 1400 b=0
Mean 1.50$ 1400

This case indicates the local currency

value is negatively correlated with dollar
price resulting into no exposure at all
irrespective of uncertain exchange rate
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 Case 3

State Prob. Price Rate Price $ Parameters

1 0.33 1000 1.40$ 1400 Cov(PS)=20/3
2 0.33 1000 1.50$ 1500 Var(S)=0.02/3
3 0.33 1000 1.60$ 1600 b=1000 GBP
Mean 1.50$ 1500

This is the special case of Transaction

cash flow showing contractual cash flow
resulting in to the known value of
exposure 1000 GBP
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 Hedging Currency Exposure
Short @ FR=1.50$,
Settle @ Future SR=1.4,1.5,1.6$ State 1 State 2 State 3 Variance
A. Case 1 (b=1700 GBP)
Asset Price (GBP) 980 1000 1070
Exchange Rate 1.40$ 1.50$ 1.60$
Value ($) 1372 1500 1712 19659
Proceeds from Forward contract 170 0 -170
$ value of Hedge Position 1542 1500 1542 392
B. Case 3 (b=1000GBP)
Asset Price (GBP) 1000 1000 1000
Exchange Rate 1.40$ 1.50$ 1.60$
Value ($) 1400 1500 1600 6667
Process from Forward contract 100 0 -100
$ value of Hedge Position 1500 1500 1500 0 8
 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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 Operating Exposure
 Note that the exposure for the
retailers has two components:
The Competitive Effect
A pound depreciation may affect operating cash flow in
pounds by altering the firm’s competitive position in
marketplace
The Conversion Effect
A given operating cash flow in pounds will be converted
into a lower dollar amount after the pound depreciation10
 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. 11
 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 their production sites to
mitigate the effect of exchange rate
movements.
e.g. 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.

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 Flexible Sourcing Policy
 Sourcing does not apply only to
components, but also to “guest
workers”.

e.g. 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.

e.g. suppose G.E. is selling power generators in Mexico

as well as in Germany. Reduced sales in Mexico due to
dollar appreciation against peso can be compensated by
increased sales in Germany due to dollar depreciation
against euro

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 R&D and Product Differentiation
 Successful R&D that 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.
e.g. Volvo, a Swedish car, Niche market for
safety minded consumers 16
 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 use of

derivative securities such as currency

swaps, futures, forwards, currency
options, among others.

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 Quiz Time
1. How would you define economic exposure
to exchange risk?
2. Explain the following statement: “Exposure
is the regression coefficient.”
3. Explain the competitive and conversion
effects of exchange rate changes on the
firm’s operating cash flow.
4. Discuss the determinants of operating
exposure.
5. Discuss the strategies for managing
operating exposure
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 Quiz Time
(1) Suppose that you hold a piece of land in the City of London
that you may want to sell in one year. As a U.S. resident,
you are concerned with the dollar value of the land. Assume
that, if the British economy booms in the future, the land
will be worth £2,000 and one British pound will be worth
$1.40. If the British economy slows down, on the other
hand, the land will be worth less, i.e., £1,500, but the
pound will be stronger, i.e., $1.50/£. You feel that the
British economy will experience a boom with a 60%
probability and a slow-down with a 40% probability.
(a) Estimate your exposure b to the exchange risk.
(b) Compute the variance of the dollar value of your property
that is attributable to the exchange rate uncertainty.
(c) Discuss how you can hedge your exchange risk exposure
and also examine the consequences of hedging.
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 Solution
(a) Let us compute the necessary parameter values:
E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580
E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44
Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2
= .00096+.00144 = .0024.
Cov(P,S)=(.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44)
= -5.28-7.92 = -13.20
b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.
You have a negative exposure! As the pound gets stronger
(weaker) against the dollar, the dollar value of your British
holding goes down (up).
(b) b2Var(S) = (-5500)2(.0024) =72,600($)2
(c) Buy £5,500 forward. By doing so, you can eliminate the
volatility of the dollar value of your British asset that is due to
the exchange rate volatility.
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 Quiz Time
 A U.S. firm holds an asset in France and
faces the following scenario:

State 1 State 2 State 3 State 4

Probability 25% 25% 25% 25%

Spot rate $1.20/€ $1.10/€ $1.00/€ $0.90/€

P* €1500 €1400 €1300 €1200

P $1,800 $1,540 $1,300 $1,080

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 In the above table, P* is the euro price of the asset
held by the U.S. firm and P is the dollar price of the
asset.

1. Compute the exchange exposure faced by the U.S.

firm.
2. What is the variance of the dollar price of this asset
if the U.S. firm remains unhedged against this
exposure?
3. If the U.S. firm hedges against this exposure using
the forward contract, what is the variance of the
dollar value of the hedged position?

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 Solution
(a)
E(S) = .25(1.20 +1.10+1.00+0.90) = $1.05/€
E(P) = .25(1,800+1,540+1,300 +1,080) = $1,430
Var(S) = .25[(1.20-1.05)2 +(1.10-1.05)2+(1.00-
1.05)2+(0.90-1.05)2]
= .0125
Cov(P,S) = .25[(1,800-1,430)(1.20-1.05) + (1,540-
1,430)(1.10-1.05)
(1,300-1,430)(1.00-1.05) + (1,080-
1,430)(0.90-1.05)]
= 30
b = Cov(P,S)/Var(S) = 30/0.0125 = €2,400.

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 Solution
(b) Var(P)
=.25[(1,800-1,430)2+(1,540-1,430)2+(1,300-
1,430)2+(1,080-1,430)2] = 72,100($)2.
(c)
Var(P) - b2Var(S) = 72,100 - (2,400)2(0.0125)
= 100($)2.
This means that most of the volatility of the
dollar value of the French asset can be
removed by hedging exchange risk. The
hedging can be achieved by selling €2,400
forward.
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 Case Study: Albion Computers
Consider Case 3 of Albion Computers PLC
Now, assume that the pound is expected to depreciate to $1.50
from the current level of $1.60 per pound. This implies that
the pound cost of the imported part, i.e., Intel’s
microprocessors, is £341 (=$512/$1.50). Other variables,
such as the unit sales volume and the U.K. inflation rate,
remain the same as in Case 3.
(a) Compute the projected annual cash flow in dollars.
(b) Compute the projected operating gains/losses over the
four-year horizon as the discounted present value of change
in cash flows, which is due to the pound depreciation, from
the benchmark case presented in Exhibit 9.6.
(c) What actions, if any, can Albion take to mitigate the
projected operating losses due to the pound depreciation?

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 Solution
a) The projected annual cash flow can be computed as follows:
______________________________________________________ c) In this case, Albion
Sales (40,000 units at £1,080/unit) £43,200,000
Variable costs (40,000 units at £697/unit) £27,880,000 actually can expect to
realize exchange gains,
Fixed overhead costs 4,000,000
Depreciation allowances 1,000,000
Net profit before tax
Income tax (50%)
£15,315,000
7,657,500 rather than losses. This
Profit after tax
Add back depreciation
7,657,500
1,000,000
is mainly due to the fact
Operating cash flow in pounds £8,657,500 that while the selling
Operating cash flow in dollars $12,986,250
______________________________________________________ price appreciates by 8%
b) ______________________________________________________ in the U.K. market, the
Variables
Benchmark
Case
Current
Case
variable cost of imported
______________________________________________________
Exchange rate ($/£) 1.60 1.50
input increased by about
Unit variable cost (£) 650 697 6.25%.
Unit sales price (£) 1,000 1,080

Albion may choose not to

Sales volume (units) 50,000 40,000
Annual cash flow (£) 7,250,000 8,657,500
Annual cash flow ($)
Four-year present value ($)
11,600,000
33,118,000
12,986,250
37,076,946 do anything.
Operating gains/losses ($) 3,958,946
______________________________________________________
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