8 - Measuring and Managing Economic Exposure

Question 1

What is foreign exchange exposure?

Answer 1

-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

Question 2

Two main forms of exchange rate risk

Answer 2

1. 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)
2. 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)

Question 3

Foreign exchange risk and economic exposure

Answer 3

• 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

Question 4

Channels of exposure to FX risk: Sales Abroad (export)

Answer 4

HC strengthens: Unfavourable; revenue worth less in home currency terms
HC weakens: favourable; revenue worth more

Question 5

Channels of exposure to FX risk: Source Abroad (import)

Answer 5

HC strengthens: favourable; inputs cheaper in HC terms

HC weakens: unfavourable; inputs more expensive

Question 6

Channels of exposure to FX risk: Profits Abroad

Answer 6

HC strengthens: unfavourable: profits worth less

HC weakens: favourable; proftis worth more

Question 7

Channels of exposure to FX risk: Competitor that sources abroad

Answer 7

HC strengthens: unfavourable; competitor’s margins improve

HC weakens; favourable; competitor’s margins decrease

Question 8

Channels of exposure to FX risk: Supplier that sources abroad

Answer 8

HC strengthens: favourable; supplier’s margins improve

HC weakens; unfavourable; supplier’s margins decrease

Question 9

Two forms of economic exposure to foreign exchange risk

Answer 9

1. Transaction exposure

2. Operating exposure

Question 10

Transaction exposure

Answer 10

-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.

Question 11

What four situations give rise to transaction exposure

Answer 11

1. purchasing on credit when prices are stated in foreign currencies
2. borrowing or lending funds when repayment is in foreign currency
3. being party to an unperformed FX forward contract
4. acquiring assets or incurring liabilities denominated in foreign currencies

Question 12

How can transaction exposure be managed?

Answer 12

-Through forward market hedging or options market hedging (see week 7)

Question 13

Operating exposure

Answer 13

• 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)

Question 14

Determinants of the IMPACT of operating exposure: Price elasticity of demand

Answer 14

• 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

Question 15

Determinants of the IMPACT of operating exposure: Degree of product differentiation

Answer 15

• 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

Question 16

Determinants of the IMPACT of operating exposure: ability to shift production and substitution of inputs

Answer 16

-The greater a company’s flexibility to substitute between home country and foreign country inputs of production, the lower the exchange rate risk

Question 17

If Home currency appreciates…

Answer 17

PRICING FLEXIBILITY IS KEY

Question 18

Measurement of Exchange Rate Risk; VaR

Answer 18

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

Question 19

Managing Operating Exposure

Answer 19

Operating exposure management required long-term adjustments and the involvement of all departments;

• Marketing management
• Product management
• Financial management

Question 20

Marketing management of Exchange risk: Market selection

Answer 20

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

Question 21

Marketing management of Exchange risk: Pricing strategy

Answer 21

-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

Question 22

Marketing management of Exchange risk: Product strategy

Answer 22

• 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

Question 23

Financial management of exchange rate risk: Financial manager’s role

Answer 23

• 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)