Chapter 10
Managing Operating Exposure to Currency Risk
Learning objectives
 Operating exposure to currency risk
–
–
Exposure of real assets
Exposure of shareholders’ equity
 Managing operating exposure
–
–
Internal hedges
Financial market (external) hedges
 Operating exposure to currency risk and the
firm’s pricing strategy
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10.1 Operating Exposures to Currency Risk
Exposures to currency risk

Economic exposure to currency risk
- Transaction exposure of monetary (contractual)
assets and liabilities
- Operating exposure of real assets

Equity exposure to currency risk
- Net monetary assets exposed to currency risk
plus the operating exposure of real assets
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10.1 Operating Exposures to Currency Risk
The law of one price revisited

In an integrated market:
- Purchasing power parity holds so that
equivalent assets trade for the same price
regardless of where they are traded.

In a completely segmented market:
- Prices are determined in the segmented,
local market.
Real-world markets fall somewhere between
these extremes.
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10.1 Operating Exposures to Currency Risk

An appreciation of the domestic currency
increases domestic purchasing power:
- This is good for importers because it increases
their purchasing power in international markets.
- This is bad for exporters as it increases the price
of their outputs in international markets.

A depreciation of the domestic currency
decreases domestic purchasing power:
- This is bad for importers because it reduces their
purchasing power in international markets.
- This is good for exporters as it decreases the
price of their outputs in international markets.
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10.1 Operating Exposures to Currency Risk
Operating exposures to currency risk (sd/f)
Revenues
Local
Operating
expenses
Global
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Local
Global
Domestic firms
(0 exposure to sd/f)
Exporters
(+ exposure to sd/f)
Importers
(– exposure to sd/f)
Global MNCs &
importers/exporters
in competitive
global markets
( ? exposure ? )
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10.2 The Exposure of Shareholders’ Equity
Foreign currency
monetary assets
40¢
Foreign currency
monetary liabilities
20¢
Net exposed
monetary assets
Domestic currency
20¢
monetary liabilities
Domestic currency
40¢
monetary assets
25¢
Real assets
exposed to
FX risk
Real assets
35¢
35¢
Equity
40¢
Equity exposure
depends on the
exposure of net
monetary assets
plus the exposure
of real assets.
A common size balance sheet
(relative to the firm’s total assets)
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10.2 The Exposure of Shareholders’ Equity
Foreign currency
monetary assets
40¢
44¢
Foreign currency
monetary liabilities
20¢
22¢
Net exposed
monetary assets
Domestic currency
= 20¢20¢
+ (4¢ –
monetary liabilities
2¢)
Domestic currency
40¢
monetary assets
25¢
Real assets
exposed to
FX risk
35¢ +35¢
2.8¢ =
Real assets
37.8¢
35¢
Equity
44.8¢
40¢
= 40¢ + 2¢ + 2.8¢
Suppose real assets have an exposure of (rCNY/sCNY/€) = 0.8
What is the effect of a 10% increase in foreign currency value?
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10.2 The Exposure of Shareholders’ Equity
Market-based estimates of exposure to the
foreign currency (i.e., Sd/f or sd/f)
βf < 0 for an importer
rd
βf > 0 for an exporter
sd/f
sd/f
rd = αd + βf sd/f + εd
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10.2 The Exposure of Shareholders’ Equity
Exposure to the domestic currency (i.e., Sf/d)
(what’s good for f is bad for d, and vice versa)
βf < 0 for an exporter
rd
βf > 0 for an importer
sf/d
Rule #1 Keep track
of your currencies
sd/f
rd = αd + βf sf/d + εd
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10.2 The Exposure of Shareholders’ Equity
An example: The U.S. auto industry’s exposures
E[r$] = μ$ + βM rM + β¥ s¥/$ + βDM sDM/$
Rule #1 Keep track
of your currencies
($ in denominator)
= 0.00 + 1.06 rM – 0.34 s¥/$ + 0.35 sDM/$
What is the expected equity return to the U.S.
automotive industry when…
rM = +10%
s¥/$ = +6%
sDM/$ = +8%
E[r$] = 0.00 + 1.06(0.10) – 0.34(0.06) + 0.35(0.08)
= 0.114, or 11.4%
Parameter estimates from Rohan Williamson, “Exchange rate exposure and competition:
evidence from the automotive industry,” Journal of Financial Economics (2001).
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10.2 The Exposure of Shareholders’ Equity
Accounting-based estimates

Sensitivity of revenues and expenses to fx rates
revtd = arevd + brevf std/f + etd
(10.7)
exptd = aexpd + bexpf std/f + etd
(10.8)
revd/f
expd/f
sd/f
sd/f
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sd/f
sd/f
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10.3 Managing Operating Exposures
in the Financial Markets
An exporter’s hedging alternatives:
-
Sell the foreign currency with long-dated
forward contracts.
-
Finance foreign projects with foreign debt.
-
Use currency swaps to acquire financial
liabilities in the foreign currency.
-
Use a rolling hedge to repeatedly sell the
foreign currency forward.
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10.3 Managing Operating Exposures
in the Financial Markets
An importer’s hedging alternatives:
-
Buy the foreign currency with long-dated
forward contracts.
-
Invest in long-dated foreign bonds.
-
Use currency swaps to acquire financial
assets in the foreign currency.
-
Use a rolling hedge to repeatedly buy the
foreign currency forward.
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10.3 Managing Operating Exposures
in the Financial Markets
Financial market hedges of operating exposure

Advantages
- Most financial market instruments are actively
traded and liquid.
- In efficient markets, financial transactions are
zero-NPV transactions.

Disadvantage
- A financial market hedge provides an imperfect
hedge of operating exposure to currency risk.
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10.3 Managing Operating Exposures
in the Financial Markets
A forward hedge of an operating exposure
+A$100,000
Expected cash flow
(long Australian dollars)
+$890,000
Sell A$ forward
(long $ & short A$)
–A$100,000
+$890,000
Net position
?A$?
Net dollar exposure
v$
s$/A$
¥
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10.4 Managing Operating Exposures
through Operations
Leverage the MNC’s ability to respond to
differences in real exchange rates
-
-
-
Plant location: Gain access to low-cost labor
or capital resources.
Product sourcing: Shift production to
countries with low real costs.
Market selection: Shift marketing efforts
toward countries with higher demand or
“overvalued” currencies.
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10.4 Managing Operating Exposures
through Operations
Operating hedges of operating exposures

Advantages
- Operating hedges create a fundamental change in
the way the MNC does business and thus a longlasting change to the company’s currency risk
exposure.
- With established international relations, the MNC
is in a good position to take advantage of
international opportunities as they arise.

Disadvantage
- Operating hedges are seldom zero-NPV
transactions.
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10.5 Pricing Strategy and
the Competitive Environment
Pricing strategy in international markets

An example
An appreciation of the dollar increases the
purchasing power of U.S. customers.
A Singapore exporter’s pricing alternatives in the
U.S. market include:
- Hold the U.S. dollar ($) price constant
You are likely to sell the same quantity in the U.S.
market at a bigger S$ profit margin per unit.
- Hold the Singapore dollar (S$) price constant
This will lower the $ price in the U.S. market and
likely lead to higher sales volume.
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10.5 Pricing Strategy and
the Competitive Environment
The price elasticity of demand


The optimal pricing strategy depends on the price
elasticity of demand for its products.
Optimal pricing depends on the price elasticity of
demand: –(DQ/Q)/(DP/P) = The sensitivity of quantity
sold to a percentage change in price.
- Price elastic demand: A small change in price results
in a large change in quantity sold.
 Lower the foreign currency price and sell more.
- Price inelastic demand: A small change in price
results in an even smaller change in quantity sold.
 Hold the foreign currency price constant and earn a
bigger contribution margin per unit.
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