2011 EXAMINATION QUESTION (4)
(a) What would a multinational firm do if it expects the local currency to
depreciate in the near term? Underline the correct answers (focus on the
italics) in what follows:
Buy/sell foreign currency forward
Go for local currency call option / put option
Reduce / increase local currency cash and marketable securities
Relax / tighten local currency credit terms
Hasten / delay collection of hard currency receivables
Borrow locally / abroad
Delay / speed up payment of accounts payable abroad
Delay / speed up dividend and fee remittances to parent company and
subsidiaries
Invoice exports in local / foreign currency
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2011 EXAM QUESTION & ANSWERS (4)
(a) A multinational firm would do the following if it expects the
local currency to depreciate in the near term:
•
Buy foreign currency forward
•
Go for local currency put option
•
Reduce local currency cash and marketable securities
•
Tighten local currency credit terms
•
Delay collection of hard currency receivables
•
Borrow locally
•
Speed up payment of account payable abroad
•
Speed up dividend and fee remittances to parent company
and subsidiaries
•
Invoice exports in foreign currency
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2011 EXAMINATION QUESTION (4)
(b) An American pension fund buys euro bonds worth EUR
10 m (upon maturity a year later) for USD 13.3 m at the
current rate of USF 1.400 per EUR. In addition, it makes a
forward sale of EUR 10 m at the forward rate of USD
1.379 per EUR.
(i) What is the cost of hedging, if the future spot rate
turns out to be:
* EUR 1= USD 1.40
* EUR 1 = USD 1.379
* EUR 1 = USD 1.30
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2011 EXAMINATION Q & A (4)
(i)

EUR1 = USD 1.40

EUR1 = USD 1.379 13.79 m – 13.79m = 0 (no loss/gain)

EUR1 = USD 1.30
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13.79 m – 14.00 m = 210 (loss)
13.79 m – 13.0 m = 790 (gain)
2011 EXAM Q & A (4)
(ii) Show how an exchange gain (loss) on the forward
market contract is offset by a corresponding exchange
loss (gain) in the value of receivable, with a total cash flow
of USD 13.79 million in all the above three instances,
resulting in a net gain of USD 490,000 (USD 13.79 m –
USD 13.3 m).
XR
VAL RECEIV
XR G/L
CF
EUR 1= $1.40
$14 m
(13.79-14 = -210) $13.79m
EUR 1= $ 1.379
$13.790 m
zero
$13.79m
EUR 1= $ 1.30
$13.0 m
(13.79-13 =+790) $13.79m
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International Finance
Economic Exposure &
Foreign Exhange Risk
LECTURE 8
Measuring Economic Exposure

The objective of managing accounting exposure, is
reducing fluctuations in translated earnings.

While it is possible for a company to show very little
translation losses, it still has to worry about underlying
volatility in currency markets.

Fluctuations in exchange rates can have ‘real’ effects
on cash-flows.

There is a major discrepancy between accounting
practice and economic reality  esp. in terms of
measuring exposure.
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Measuring Economic Exposure
(cont’d)
In contrast to accounting definition, economic
definition focuses on the impact of an exch. rate 
on cash flows.
So, economic exposure is about the  in PV of CF
as a result of  in exchange rates.
Economic exposure  simply, impact of exchange
rate  on future cash flows.



2
components
Econ. Exposure
Transaction Exposure
Operating Exposure
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Measuring Economic Exposure
(cont’d)

We’ve already seen that transaction exposure stems from
exchange gains or losses on foreign currency denominated
contractual obligations.

Though transaction exposure is included in accounting
exposure, it really is economic exposure since contractual
obligations mean  in future transaction cash flows.

Operating exposure arises because currency fluctuations can
alter a company’s revenues and costs – i.e. operating cash flows.

Thus, operating exposure is much more comprehensive and
long term in nature (unlike transaction exposure that
measures  in CF due to individual transactions). It is far
more pervasive.
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Measuring Economic Exposure
(cont’d)

Operating Exposure  views the firm as an ongoing
concern with operations whose cost and price
competitiveness could be affected by exchange rate s.

The firm faces operating exposure the moment it
invests in servicing a market subject to foreign
competition  or in sourcing goods or inputs abroad.

i.e.  a firm could face operating exposure even if it
has not invested abroad.

Since,
economic
exposure
is
much
more
comprehensive, it is more difficult to measure than
accounting exposure.
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Real and Nominal ER Changes

Before going on, recall from PPP the diff. between real and nom. exch. rate s.
et'  et 
(1  if , t )
(1  ih, t )

The distinction between real and nominal exch. rate  is important, since
they have vastly different effects on economic exposure.

A  in relative price level should leave the real rate unchanged.

As long as real exchange rates have not , there should be no change
in competitiveness and therefore very little  in economic exposure.

So, for economic exposure, what really matters is  in
RER not  in NER.
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Operating Exposure

A real exchange rate  affects a number of firm’s
operations  and therefore induces operating
exposure  it certainly leads to  in competitiveness.

The impact however depends on a number of factors:





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Pricing flexibility (demand side)
Production flexibility (supply side)
Foreign subsidiary’s degree of competition
Extent of local inputs in production
Export dependence  ratio of exports to total sales
Operating Exposure (cont’d)
(1) Pricing Flexibility :- Suppose HC appreciates, then obviously a domestic
firm’s competitiveness is affected.
 Profit margins in $ terms on both foreign and domestic sales could be
squeezed
 $ price of even domestic sales may be affected by now “lower priced
imports”.

The extent of how badly a company could be squeezed will depend on
it’s pricing flexibility and esp. its price elasticity of DD.

If the company’s products have low price elasticity (because its
differentiated, or has snob appeal, or strong customer loyalty
or
produces an essential good and has “monopoly” power, etc.) then the co.
has pricing flexibility.

Such a co. would be able to (a) keep the same $ price by  FC price (b)
would not lose much market share to foreign competition both
domestically and internationally, and so (c) will be able to maintain its
long term $ profits and cash flow about the same.
*The opposite is true for a co. with high price elasticity.
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Operating Exposure (cont’d)
(2) Production Flexibility (supply side)

The ability to shift production and the sourcing of inputs
among countries can determine the extent to which a
company would be susceptible to exchange risk.

The higher the production flexibility, the less the exchange
risk.

Shifting production to (or sourcing inputs from) a country
with depreciating currency or decreasing inputs from
appreciating currency sources obviously helps  risk.
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Operating Exposure (cont’d)
(3) Foreign subsidiary’s degree of competition

For a company or MNC with a foreign subsidiary, the degree and
type of competition (domestic & foreign) faced by the subsidiary
can determine the economic exposure of the parent company.

If foreign subsidiary is producing and selling in the domestic
market, a LC devaluation will hurt (via import content). But, if it
is exporting, the LC devaluation effect is mitigated since the
subsidiary’s export competitiveness will  .

Likewise, with LC devaluation, the subsidiary’s foreign
competitors exporting into the foreign subs. operating country
will face price disadvantage  and therefore once again the effect
of LC devaluation is mitigated.
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Operating Exposure (cont’d)
(4)

The higher the local input content in production, the
greater the advantage of LC devaluation, since $ costs of
production would be less.
(5)

Extent of Local Inputs
Extent of Exports
LC devaluation, for a foreign subsidiary that exports most
of products, could mean windfall profits, since export
earnings will remain the same, if not increase (depending
on demand elasticity), but production costs would be falling
in $ terms following LC devaluation.
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Operating Exposure (cont’d)

*The main conclusion of all this is that the following factors are
far more important in determining a firm’s true economic
exposure than that of any accounting definition:




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the sector of the economy in which the firm operates (whether
import–competing, exporting or selling non-traded items)
the sources of inputs (whether imported or local) and
the extent fluctuations in real exchange rate
For e.g., a company which produces cars based
domestic inputs for the domestic market would
accounting exposure, yet it would have extensive
exposure since its competing against the Japanese
foreign automakers.
solely on
have zero
economic
and other
The “Currency Habitat” Argument & 3 Illustrative
Cases Summary

1.
Aspen Skiing


Currency Habitat
Revenues 
$
Costs

$
No accounting exposure. Yet, the $ appreciation  revenues (Americans going to Alps instead of Colorado Rockies - for skiing!) but kept costs the same  causing problems
(economic exposure)
Petroleos Mexicanos 
Revenues 
$

costs

Peso
(Accounting and economic exposures) Gains from $ appreciation and losses from $
depreciation. Costs in $ terms fall if $ appreciates (rise if $ depreciates)

2.

3.
Toyota Motor Company  Revenues  $ and ¥  ½ of cars exported to US.
Costs
 $ and ¥  steel, copper aluminum
oil (inputs denom in $)
Cost of imported inputs fall as yen appreciates; domestic costs stay the same; exports
fall. Thus lower yen revenues and higher yen costs.Yen appreciation hurts Toyota, as
profits drop
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“Currency Habitat” Argument and Summary of
the 3 Illustrative Cases (cont’d)

Where both revenues and costs are in multiple currencies the effect is
ambiguous  it depends on exact breakdown by currency etc.

4.
Suppose you had a 4th Case where Revenue  in USD
Cost  in EUR
and if USD depreciates against EUR, this company will be in serious trouble,
as revenue will fall with unchanged cost in euro terms (or unchanged revenue and
rising cost in dollar terms)
Conclusion:

Thus, the extent of economic exposure will depend on the currency
habitat and which currency appreciates or depreciates.

Also, as in the case of Aspen Ski, you could have an entirely domestically
oriented company that could have extensive economic exposure.
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Calculating Economic Exposure

Recall that economic exposure is the  in PV of CF; thus,
calculating economic exposure means estimating future cash
flows and determining how these cash-flows would  when
exchange rates .

This implies estimating cash-flows under diff. scenarios  where
the scenarios  according to diff. assumptions of  in items like
costs, product prices, revenues, etc.

As the input assumptions , the PV of CF computed under one
scenario would differ from that of an earlier / diff scenario.

The assumptions are extremely important (assumption of price –
elasticity, input mix, etc) in the calculation of CF .
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Calculating Economic Exposure

So, in estimating economic exposure, you ask yourself how CF will
, and what is the most likely scenario; the CF derived from the
most likely scenario would then be “the best” estimate of the
impact of economic exposure (worst-case, baseline, best-case).

Based on these likely scenarios and likely economic exposure, you
ask yourself.
 Is this project/foreign investment still worth the trouble?


and;
If the investment has already been made, what action would
you take to reduce the economic exposure?
Note: Accounting exposure (esp. translation) exposure is based
on historical events, whereas economic exposure is forward
looking by definition.
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Measuring Exchange Risk

Since the measure of economic exposure (i.e -  in PV
of CF) is dependent on the assumptions you make 
it really involves a lot of judgment & intuition.

One workable way to determine a firm’s economic
exposure without having to rely solely on assumptions
is to examine historical data.

The basic idea is to determine the correlation
between  in CF with  in nominal exchange rates.

This, by definition, means the said technique cannot be
used for a brand new investment/proposed foreign
venture.
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An Operational Measure of Exchange Risk

A simple way to establish the correlation between CF
and ER is through the use of a regression analysis.
The regression model could be as follows:
CFt     EXCHt  et
Where:
= the $ value of total CF in period t
EXCH = average NER during period t
et = random error with mean o.
CFt
t
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An Operational Measure of ER Risk (cont’d)

The beta  measures the sensitivity of CF to exchange rate s.

Higher the beta  the greater the sensitivity, higher the
exposure.

Another regression output statistics that is important would be
the R2 stat  which measures the strength of the relationship. 
a low R2 means, the regression relation is unimportant in
explaining CF ’s due to exchange rate s.

The major weakness with this technique is that it uses historical
data.

A caution is in order: note that we are assuming the future would
be pretty much like the past  may not be a great assumption.
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MANAGING OPERATING
EXPOSURE
Operating exposure management requires
long-term operating adjustments.
A. Real vs Nominal Changes
RER will not change if the NER change is offset fully by a change in price
level (inflation), in which case there will be no gain/loss in
competitiveness, and therefore will not alter CF.
Surely, changes in RER will cause relative price changes: (i.e. prices of
domestic goods relative to prices of foreign goods) – which will affect CF.
Relative price changes lead to marketing and/or production revisions.
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MANAGING OPERATING
EXPOSURE (cont’d)
B.
Proactive Marketing and Production
Initiatives
Marketing:
market selection
pricing strategy
product strategy
production structure
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MANAGING OPERATING EXPOSURE
(cont’d)
Market Selection



Appreciation of FC offers competitive advantage to, say, US
goods in the foreign market
Select markets where the LC is strong or potentially strong visà-vis HC
Pick markets where foreign competitors likely to lose out if their
currencies get stronger
Pricing Strategy



Choice between market share and profit margin (go for bigger
market share or bigger profit margin).
Depreciation of HC: the strategy is to either (a) raise HC prices
and keep foreign price constant, to raise profit margin or (b)
allow foreign prices to fall and increase market share
Much depends on price elasticity of DD and scale economies
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MANAGING OPERATING EXPOSURE
(cont’d)
Product Strategy




HC depreciation provides opportunity to develop a
brand franchise (competitive price advantage)
HC depreciation allows a firm to expand product line
and cover a wider spectrum of consumers at home &
abroad
HC appreciation may force a firm to target at up-end
markets
Strong yen forced Japanese exporters to focus on
more sophisticated, high-value products that are less
sensitive to price increases caused by yen appreciation
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MANAGING OPERATING EXPOSURE
(cont’d)

Production Structure

HC appreciation may be accompanied by shifting the
manufacturing base overseas (e.g. German & Japanese
automakers)
Alternatively, change the input mix by buying more
components overseas (outsourcing by US firms)
MNCs may opt for shifting production among plants in
different country locations, diversification to reduce
operating exposure (Japanese car manufacturers)
HC appreciation would force firms to raise
productivity (closing down of inefficient plants;
employee motivation, slashing variety)



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SUMMARY & CONCLUSIONS
*Accounting profession’s focus on balance sheet impact of
exchange rate changes bypasses the more important
impact on future cash flows,
*Real, not nominal, exchange rates hold the key to
measuring economic exposure.
*The impact of exchange rate changes on a firm depends on
many variables such as the location of its major markets
and competitors, supply and demand elasticity,
substitutability of inputs (local against foreign) and
offsetting inflation.
*Since currency risk affects all facets of a company’s
operations, it should not be the concern of financial
30managers alone.
SUMMARY & CONCLUSIONS (cont’d)
* Operating managers have to develop marketing and
production initiatives so as to ensure long-run
profitability.
* The key to effective exposure management is to integrate
currency considerations into the general management
process.
* In an integrated exchange risk programme, the role of
financial executive is to (a) provide forecasts of inflation
and exchange rates; (b) identify and highlight the risks of
competitive exposure; (c) estimate and hedge the
remaining operating exposure (after the above-mentioned
efforts)
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END OF LECTURE 8
Be Cool, Stay Calm, No Worries!
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