topic 6 (1) Flashcards
currency mismatch
the costs and revenues are not matched in individual currencies
what is economic exposure
economic exposure is about how the value of the firm would be affected by unexpeected surprises in exchange rates
such changes in the exchange rates can have a sizable effect on the firms competitive position, and therefore on its cash flows and market value
example of economic exposure
if the US dollar depreciates against the japanese yen, it would strengthen the competitive position of the US car makers at the expense of Japanese car makers
Example 2)
When the value of US dollar changes, domestic firms with no foreign payable/receivable may also loose their competitive position in the market
consider us bicycle manufacturer in texas only operating in the US market
When US dollar appreciates, Taiwanese imported bicycles would be much cheaper for the US consumers
Does economic exposure really matter?
what do researchers say
exchange rates can systematically affect the value of the firm
There is a significant relationship exists between stock return and dollar value
US stock returns are sensitive to exchange rate movements
exposure coefficient b formula
b = cov(P,S)/Var(S)
where P = Dollar value of british asset
S = Dollar/pound exchange rate
The exposure can be measured by the coefficient b in the following regression equaiton
P = a + b*S + e
Where a = regression constant
e = random error term with mean zero (E(e) = 0)
P = Dollar value of british asset
S = dollar/pound exchange rate
variance decomposition
P = a+bS+e
Var(P) = Var(a + bS + e)
= b^2*Var(S)+Var(e)
where Var(e) = residual and the rest is related to the random changes in the exchange rate
operating exposure
extent to which the firms operating cash flows are affected by the exchange rate
The direct (positive or negative) effect of converting foreign assets into your domestic currency at a changed interest rate is called conversion effect
New: in the long run, changes in the exchange rate may affect the firms competitive position
determinants of operating eposure
Operating exposure cannot be readily determined from the firms accounting statements unlike transaction exposure
A firm is subject to high degrees of operating exposure when either its cost or its price is sensitive to exchange rates
A firms operating exposure is determined by
1) Market structure (the structure of the markets in which the firm sources its inputs, such as labor and materials and selling its products
2) Firms ability to mitigate the exposure (The firms ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix and sourcing
facing exchange rate changes a firm may choose one of the three pricing strategies
1) pass the cost shock fully to its selling prices (complete pass through)
2) Fully absorb the shock to keep its selling unaltered (no pass through)
3) Do some combination of the two strategies (partial pass-through)
firms may use the following strategies for managing operating exposure
selecting low-cost production sites
Flexible sourcing policy
Diversification of the market
Product differentiation and RD efforts
Financial hedging
selecting low cost production site
Diversify the location of production sites to mitigate the effect of exchange rate movements
Advantages: great deal of flexibility regarding where to produce
Disadvantage: maintaining multiple manufacturing sites is costly and may prevent from taking advantage of economies of scale
Flexible sourcing (import from where costs are low)
Flexible sourcing policy is a strategy for managing operating exposure that involves sourcing from areas where input costs are low
Diversification of the market
Diversifying the market for the firms products is another way to managing exchange exposure
Can firms reduce currency exposure by diversifying different business lines?
Conglomerate expansion strategies may bring about efficinecy and losses
The firm should not soley enter to a new line of business for diversification exchange rate risk
R&D efforts and product differentiation
investment in research and development (R&D) can allow the firm to maintain and strengthen its competitive position in the face of adverse exchange rate movements
Successful R&D allows
cost cutting
enhanced productivity
Product differentiation
Financial Hedging
Goal: stabilize the firms cash flows in the near term
Use of derivative securities such as currency swaps, futures, forwards, currency options (among many, many others)
Operational hedging
Redeploying resources in order to shift dollar costs to other currencies
E.g. relocating employees, manufacturing and research sites
Would operational hedging work?
not a practical solution + not cost effective either
Financial hedging
using financial derivatives and money market options
e.g. Forwards & futures contracts, options, investing in local currencies etc.
Would it work?
maybe to some extent
5 step procedure on financial hedging
1) exchange forecasting
2) assessing strategic plan impact
3) Hedging rationale
4) FInancial instruments
5) hedging program
exchange forecasting
involving probabilities of adverse exchange movements (expected and unexpected surprises)
Estimate future rate ranges (within a confidence interval)
Identify the major factors affecting FX rate movements
For ex. US trade deficit, capital flows, the US budget deficit, and gov’t policies etc.
assessing strategic plan impact
cash flows and earnings are projected and compared under the alternative exchange rate scenarios
For ex. strong dollar or weak dollar scenarios
Make projectsion for 5 year cumulative basis
Usually cumulative plans work better than year to year plans in long term decision making
Hedging rational
Deciding to hedge or not to hedge
Listing the reasons for hedging
E.g. Currency matcing
Meeting strategic goals
Financial instruments
searching for the most cost effecting hedging tool
Available financial technology set: forwards, options and foreign currency borrowings
Hedging program
formulating an implementation strategy –> optimization process
E.g. what strike prices of the options
which percentage to be covered
Simulate the outcome of various strategies (good vs normal vs bad economy )
