8 - Measuring and Managing Economic Exposure Flashcards
What is foreign exchange exposure?
-A measure of the potential that a firm’s profitability, net cash flow, and market value, may CHANGE because of a change in EXCHANGE RATES
Two main forms of exchange rate risk
- Translation exposure: risk that arises from the translation of the assets and liabilities in a balance sheet into a foreign currency (that their value will change)
- Economic exposure: the exposure of a business selling goods abroad or buying goods from abroad to the risks resulting from changes in exchange rates (how CFs and price/cost competitiveness will be affected)
Foreign exchange risk and economic exposure
- FX risk management involves incorporating currency change expectations into all basic decisions of the firm
- How the PV of a firm’s expected future cash flows are affected when exchange rates change
Channels of exposure to FX risk: Sales Abroad (export)
HC strengthens: Unfavourable; revenue worth less in home currency terms
HC weakens: favourable; revenue worth more
Channels of exposure to FX risk: Source Abroad (import)
HC strengthens: favourable; inputs cheaper in HC terms
HC weakens: unfavourable; inputs more expensive
Channels of exposure to FX risk: Profits Abroad
HC strengthens: unfavourable: profits worth less
HC weakens: favourable; proftis worth more
Channels of exposure to FX risk: Competitor that sources abroad
HC strengthens: unfavourable; competitor’s margins improve
HC weakens; favourable; competitor’s margins decrease
Channels of exposure to FX risk: Supplier that sources abroad
HC strengthens: favourable; supplier’s margins improve
HC weakens; unfavourable; supplier’s margins decrease
Two forms of economic exposure to foreign exchange risk
- Transaction exposure
2. Operating exposure
Transaction exposure
-Risk that the cost of transaction will change because of exchange rate movements between the date of the transaction and the date of the settlement.
What four situations give rise to transaction exposure
- purchasing on credit when prices are stated in foreign currencies
- borrowing or lending funds when repayment is in foreign currency
- being party to an unperformed FX forward contract
- acquiring assets or incurring liabilities denominated in foreign currencies
How can transaction exposure be managed?
-Through forward market hedging or options market hedging (see week 7)
Operating exposure
- Arises because currency fluctuations alter a company’s future revenues and expenses by affecting the price and cost competitiveness of a firm that is involved in cross-border trading
- A decline in the real value of domestic currency makes exports more competitive. An appreciating currency makes imports more competitive
- Elasticity: also, if a product is highly specialised, it is less affected by FX risk than common goods (as customers just change)
Determinants of the IMPACT of operating exposure: Price elasticity of demand
- Percentage change in quantity demanded of a good to a percentage change in the price
- The greater the price elasticity of demand, the less flexibility the company will have to respond to exchange rate changes
Determinants of the IMPACT of operating exposure: Degree of product differentiation
- The less differentiated a company’s products are and the more internationally diversified its competitors are, the greater the price elasticity of demand for the good
- E.g. Mercedes Benz, commodity-type products
Determinants of the IMPACT of operating exposure: ability to shift production and substitution of inputs
-The greater a company’s flexibility to substitute between home country and foreign country inputs of production, the lower the exchange rate risk
If Home currency appreciates…
PRICING FLEXIBILITY IS KEY
Measurement of Exchange Rate Risk; VaR
The Value at Risk measure of exchange rate risk is used by firms to estimate the riskiness of a foreign exchange position resulting from a firm’s activities, including the foreign exchange position of its treasury, over a certain time period under normal conditions
Managing Operating Exposure
Operating exposure management required long-term adjustments and the involvement of all departments;
- Marketing management
- Product management
- Financial management
Marketing management of Exchange risk: Market selection
Selection of markets in which to sell (sell in strong currencies, produce in weak). Use competitive advantage to carve out market share when currency values change
Marketing management of Exchange risk: Pricing strategy
-Trade off to decide whether to emphasise on (i) market share or (i) profit margin
-If HC appreciates and exporters lose competitive advantage, they can:
1. hold the foreign price constant - loss of market share
2. reduce foreign price - reducing profit margin
Which step to take depends largely on price elasticity of demand
Marketing management of Exchange risk: Product strategy
- Companies often respond to exchange rate changes by altering product strategies, such as introduction of new products
- Timing is crucial: period after HC devaluation is ideal to introduce new product, and increase product line (and vice-versa)
- Shifting production among plants: increase production in country whose currency has devalued and decrease in country which has had currency appreciation
- Planning for exchange-rate changes: develop contingency plans with plausible scenarios before the impact of a currency change is realised
Financial management of exchange rate risk: Financial manager’s role
- Structure the firm’s liabilities in such as way that the reduction in asset earnings is matched by corresponding decrease in cost of servicing liabilities
- A firm that has developed a large export market in a particular country should hold a portion of its liabilities in that country (e.g. loans)
