Cov(P,S) Var(S)
CFIN 621- Chapter 12- Management of Economic Exposure THREE TYPES OF EXPOSURE • Economic exposure—extent to which the value of the firm is affected by unanticipated changes in exchange rates o Anticipated changes—already be discounted and reflected in the firms value o Unanticipated changes—profound effect on the firms competitive position—cash flow and market value • Transaction exposure—sensitivity of realized domestic currency values of the firms contractual cash flows denominated in foreign currencies to unexpected exchange rate changes o Short term exposure o Arises from fixed price contracting in the world where exchange rates change randomly • Translation exposure—potential that firms consolidated financial statements affected by changes in exchange rate o Consolidation involves translation of subsidiaries financial statements from local currencies to the home country o Gains and losses represent the account systems attempt to measure economic exposure ex post HOW TO MEAUSRE ECONOMICN EXPOSURE • Currency risk—random changes in exchange rates o Not the same as currency exposure—what is at risk • Insensitive to exchange rate changes—embedded hedge against exchange risk • Sensitive to the exchange rate—local price of your company’s asset barely changes o Operating cash flow are sensitive to exchange rate changes—exposed to currency risk • Exposure to currency risk can be properly measured by sensitivities of o Future home currency values of the firms asset o Firms operating cash flows to random changes in exchange rates • P=a+bS+e o P=SP* p* local currency price of the asset o Regression coefficient b—sensitivity of the dollar of the asset to the exchange rate B=0 dollar value of the asset is independent of exchange rate movements —no exposure
• •
Exposure coefficient—
b=
Cov (P , S) Var (S)
Decompose the variability of the dollar value od the asset Var (P)—Exchange rate related and residual o B2Var(S)—part of the variability of the dollar value of the asset that is related to random changes in the exchange rete o Var(E)—residual part of the dollar value variability that is independent of exchange rate movements • Once exchange expose is hedged, most of the variability of the dollar value of the asset is eliminated OPERATING EXPOSURE: DEFINITION • Economy becomes increased globalized—more firms are subject to international competition • Fluctuating exchange rates—alter the relative competitive positions of such firms in domestic and foreign markets o Affecting operating cash flows • Exposure of operating cash flows depends on the effect of the exchange rate changes on the firms competitive position not readily measureable • Operational exposure may account for a larger portion of the firms total exposure thant contractual exposure • Operating exposure—extent to which the firms operating cash flows would be affected by changes in exchange rates ILLUSTRATION OF OPERATING EXPOSURE • Dollar operating cash flow changes following depreciation of currency
1
o
Competitive effect—depreciation may affect operating cash flow by altering the firms competitive position in the marketplace o Conversion effect—given operating cash flow in currency will be converted into a lower dollar amount after the currency depreciation • Varying degrees of realism o No variable changes except the price of the important input Asymmetry makes the firms operating cash flow sensitive to exchange rate changes— giving rise to operating exposure o Selling price as well as the price of the imported input changes with no other changes Depreciation need not always lead to a lower dollar operating cash flow o All the variables changes DETERMINANTS OF OPERATING EXPOSURE • Operating exposure is determined by o Structure of the market—firms sources its inputs—labour and materials and sells its products o Firms ability to mitigate the effect of exchange rate changes by adjusting its marketsproduct mix and sourcing • Exchange rate pass through • Firm is subject to high degrees of operational exposure—either its cost to its price is sensitive to exchange rate changes o Both cost and price are sensitive or insensitive to exchange rate changes—firm has no major operating exposure • Market structure—extent to which a firm is subject to operating exposure depends on the firms ability to stabilize cash flows in the face of exchange rate changes o Firms flexibility regarding production locations, sourcing and financial hedging strategy is an important determent of its operating exposure to exchange risk • Changes in nominal exchange rates—not always affect the firms competitive position o Change in exchange rate is exactly offset by the inflation differential • PPP doesn't hold very well—short run—exchange rates changes are likely to affect the competitive positions of the firms that are sourcing from different locations but selling in the same market • Exchange rate changes—pricing strategies o Pass the cost shock fully to its selling prices (complete pas through) o Fully absorb the shock to keep its selling unaltered (no pass through) o Do some combination of the 2 strategies described above (partial pass through) • Import prices generally do not fully reflect exchange rate changes—exhibiting a partial pass through phenomenon • Pricing behavior of foreign exporting firms—consistent with partial pass through • Import prices are affected relatively little by exchange rate changes in industries with low product differentiation—high demand elasticity’s • Industries with a high degree of product differentiation—low demand elasticity’s, import prices tend to change more following an exchange rate change PASS-THROUGH CANADIAN EVIDENCE • Industries involved in products for which domestically produced goods are close substitutes for imported goods o Automobiles—tend to have higher pass through • Foreign producers adjust their export prices to match the price in the destination market • Industries involved in relatively unique products that do not have close substitutes tend to be more insulated from exchange rate changes o Exhibit low exchange rate pass through o Under less pressure to price to the market in the domestic country MANAGING OPERATING EXPOSURE • Cash flows of firms can be quite sensitive to exchange rate changes • Objective of managing operating exposure—stabilize cash flows in the face of fluctuating exchange rates • Firm exposed to exchange risk mainly through the effect of exchange rate changes on its competitive position—consider exchange exposure management in the context of the forms long term strategic planning • Managing exposure – not a short term tactical issue
2
CFIN 621- Chapter 12- Management of Economic Exposure SELECTING LOW-COST PRODUCTION SITES • Domestic currency—strong or expected to become strong, eroding the competitive position of the firm o Choose to locate production facilities in a foreign country—costs are low due to either the undervalued currency or underpinned factors of production • Firm can choose to establish and maintain production facilities in multiple countries to deal with the effort of exchange rate changes • Multiple manufacturing sites—may prevent the firm from taking advantage of economies of scale, raising cost of production o Higher cost can partially offset the advantages of maintaining multiple production sites FLEXIBLE SORCING POLICY • Firm manufacturing facilities only in the domestic country—substantially lessen the effect of exchange rate changes by sourcing from where input costs are low • Dollar was strong against most major currencies—multinational firms purchased materials and components from low-cost foreign suppliers • Flexible sourcing policy—need to be confined just to materials and parts • Firms can hire low-cost guest workers from foreign countries instead of high cost domestic workers in order to be competitive DIVERSIFICATION OF THE MARKET • Geographically diversifying the firms sales pattern • Geographic diversification of sales—risk moderating effect • Firm can reduce currency exposure by diversifying across different business line • Each individual business my bay be exposed to exchange risk to some degree firm as a whole may not face a significant exposure • Firm should not get into new lines of business solely to diversify exchange risk conglomerate expansion can bring about inefficiency and losses R&D EFFORTS AND PRODUCT DIFFERENTIATION • Allow the firm to maintain and strength its competitive position in face of adverse exchange rate movements • Successful—firms to cut costs and enhance productivity • Lead to product differentiation introduction of new and unique products for which competitors offer no close substitute • Demand for unique products tend to be highly inelastic—firm would be less exposed to exchange risk • Firm can strive to create perception among consumers—different from those offered by competitors • Firm acquires unique identity—demand is less likely to be price sensitive FINANCIAL HEDGING • Financial hedging—used to stabilized firms cash flow o i.e firms can lend or borrow foreign currencies on a long term basis • Financial contracts—designed to hedge against nominal rather than real changes in exchange rates • Firms competitive position—affected by real changes in exchange rates o Financial contracts can best provide an approximate hedge against the firms operating exposure • Operational hedges—redeployment of resources—costly or impractical • Financial contracts—provide the firm with flexible and economical ways of dealing with exchange exposure HOW CANADIAN FIRMS DEAL WITH ECONOMICN EXPOSURE • Firms most adversely affected tended to be in all manufacturing sector—primary industries o Benefited were largely in retail and wholesale trade and in transportation o Least affected by the appreciation were predominantly in non treaded sectors Construction, finance, insurance, and real estate and personal service • Adverse impact of the appreciation stemmed largely from lower profit margins on foreign sales— many goods are priced in US dollars o Favorably affected firms generally benefited from lower input costs MANAGERIAL AND STRATEGIC PERSPECTIVES ON ECONOMIC EXPOSURE • Major multinational firms do not attempt to hedge economic exposure
3
• •
• • • • • • •
4
Economic exposure—longer term phenomenon wherein the value of a firms foreign operations o Based on costs and revenues in foreign currency o Potentially effected by changes in exchange rates Exchange rates moved rapidly and smoothly to maintain purchasing power parity o Economic exposure would be used not be an issue at all o International law of one price—hold and exchange rates would not matter for international industry PPP does not hold in the short term Longer time—speed of adjustment to PPP can be sporadic—price rigidities and exchange rate changes that are induced more by capital flows than relatively prices of industrial inputs or product prices Crux of economic exposure—risk of protected deviations from PPP—affect the cost structure and competitive position of a multinational firm Hedging the long term consequences of real exchange rate changes—substantially more complicated than hedging either transaction or translation Biggest problem setting up a strategy to hedge economic exposure—firm was so inclined o Estimate the longer term effects of exchange rate changes on the firms cash flow Difficulty assessing effect of exchange rate changes on cash flows—predicting the underlying cause of the exchange rate movement Cannot predict—future exchange rate fluctuations are in line with relative price changes o Forward and futures contracts—standard tools for hedging transaction exposure
• •
Exposure coefficient—
b=
Cov (P , S) Var (S)
Decompose the variability of the dollar value od the asset Var (P)—Exchange rate related and residual o B2Var(S)—part of the variability of the dollar value of the asset that is related to random changes in the exchange rete o Var(E)—residual part of the dollar value variability that is independent of exchange rate movements • Once exchange expose is hedged, most of the variability of the dollar value of the asset is eliminated OPERATING EXPOSURE: DEFINITION • Economy becomes increased globalized—more firms are subject to international competition • Fluctuating exchange rates—alter the relative competitive positions of such firms in domestic and foreign markets o Affecting operating cash flows • Exposure of operating cash flows depends on the effect of the exchange rate changes on the firms competitive position not readily measureable • Operational exposure may account for a larger portion of the firms total exposure thant contractual exposure • Operating exposure—extent to which the firms operating cash flows would be affected by changes in exchange rates ILLUSTRATION OF OPERATING EXPOSURE • Dollar operating cash flow changes following depreciation of currency
1
o
Competitive effect—depreciation may affect operating cash flow by altering the firms competitive position in the marketplace o Conversion effect—given operating cash flow in currency will be converted into a lower dollar amount after the currency depreciation • Varying degrees of realism o No variable changes except the price of the important input Asymmetry makes the firms operating cash flow sensitive to exchange rate changes— giving rise to operating exposure o Selling price as well as the price of the imported input changes with no other changes Depreciation need not always lead to a lower dollar operating cash flow o All the variables changes DETERMINANTS OF OPERATING EXPOSURE • Operating exposure is determined by o Structure of the market—firms sources its inputs—labour and materials and sells its products o Firms ability to mitigate the effect of exchange rate changes by adjusting its marketsproduct mix and sourcing • Exchange rate pass through • Firm is subject to high degrees of operational exposure—either its cost to its price is sensitive to exchange rate changes o Both cost and price are sensitive or insensitive to exchange rate changes—firm has no major operating exposure • Market structure—extent to which a firm is subject to operating exposure depends on the firms ability to stabilize cash flows in the face of exchange rate changes o Firms flexibility regarding production locations, sourcing and financial hedging strategy is an important determent of its operating exposure to exchange risk • Changes in nominal exchange rates—not always affect the firms competitive position o Change in exchange rate is exactly offset by the inflation differential • PPP doesn't hold very well—short run—exchange rates changes are likely to affect the competitive positions of the firms that are sourcing from different locations but selling in the same market • Exchange rate changes—pricing strategies o Pass the cost shock fully to its selling prices (complete pas through) o Fully absorb the shock to keep its selling unaltered (no pass through) o Do some combination of the 2 strategies described above (partial pass through) • Import prices generally do not fully reflect exchange rate changes—exhibiting a partial pass through phenomenon • Pricing behavior of foreign exporting firms—consistent with partial pass through • Import prices are affected relatively little by exchange rate changes in industries with low product differentiation—high demand elasticity’s • Industries with a high degree of product differentiation—low demand elasticity’s, import prices tend to change more following an exchange rate change PASS-THROUGH CANADIAN EVIDENCE • Industries involved in products for which domestically produced goods are close substitutes for imported goods o Automobiles—tend to have higher pass through • Foreign producers adjust their export prices to match the price in the destination market • Industries involved in relatively unique products that do not have close substitutes tend to be more insulated from exchange rate changes o Exhibit low exchange rate pass through o Under less pressure to price to the market in the domestic country MANAGING OPERATING EXPOSURE • Cash flows of firms can be quite sensitive to exchange rate changes • Objective of managing operating exposure—stabilize cash flows in the face of fluctuating exchange rates • Firm exposed to exchange risk mainly through the effect of exchange rate changes on its competitive position—consider exchange exposure management in the context of the forms long term strategic planning • Managing exposure – not a short term tactical issue
2
CFIN 621- Chapter 12- Management of Economic Exposure SELECTING LOW-COST PRODUCTION SITES • Domestic currency—strong or expected to become strong, eroding the competitive position of the firm o Choose to locate production facilities in a foreign country—costs are low due to either the undervalued currency or underpinned factors of production • Firm can choose to establish and maintain production facilities in multiple countries to deal with the effort of exchange rate changes • Multiple manufacturing sites—may prevent the firm from taking advantage of economies of scale, raising cost of production o Higher cost can partially offset the advantages of maintaining multiple production sites FLEXIBLE SORCING POLICY • Firm manufacturing facilities only in the domestic country—substantially lessen the effect of exchange rate changes by sourcing from where input costs are low • Dollar was strong against most major currencies—multinational firms purchased materials and components from low-cost foreign suppliers • Flexible sourcing policy—need to be confined just to materials and parts • Firms can hire low-cost guest workers from foreign countries instead of high cost domestic workers in order to be competitive DIVERSIFICATION OF THE MARKET • Geographically diversifying the firms sales pattern • Geographic diversification of sales—risk moderating effect • Firm can reduce currency exposure by diversifying across different business line • Each individual business my bay be exposed to exchange risk to some degree firm as a whole may not face a significant exposure • Firm should not get into new lines of business solely to diversify exchange risk conglomerate expansion can bring about inefficiency and losses R&D EFFORTS AND PRODUCT DIFFERENTIATION • Allow the firm to maintain and strength its competitive position in face of adverse exchange rate movements • Successful—firms to cut costs and enhance productivity • Lead to product differentiation introduction of new and unique products for which competitors offer no close substitute • Demand for unique products tend to be highly inelastic—firm would be less exposed to exchange risk • Firm can strive to create perception among consumers—different from those offered by competitors • Firm acquires unique identity—demand is less likely to be price sensitive FINANCIAL HEDGING • Financial hedging—used to stabilized firms cash flow o i.e firms can lend or borrow foreign currencies on a long term basis • Financial contracts—designed to hedge against nominal rather than real changes in exchange rates • Firms competitive position—affected by real changes in exchange rates o Financial contracts can best provide an approximate hedge against the firms operating exposure • Operational hedges—redeployment of resources—costly or impractical • Financial contracts—provide the firm with flexible and economical ways of dealing with exchange exposure HOW CANADIAN FIRMS DEAL WITH ECONOMICN EXPOSURE • Firms most adversely affected tended to be in all manufacturing sector—primary industries o Benefited were largely in retail and wholesale trade and in transportation o Least affected by the appreciation were predominantly in non treaded sectors Construction, finance, insurance, and real estate and personal service • Adverse impact of the appreciation stemmed largely from lower profit margins on foreign sales— many goods are priced in US dollars o Favorably affected firms generally benefited from lower input costs MANAGERIAL AND STRATEGIC PERSPECTIVES ON ECONOMIC EXPOSURE • Major multinational firms do not attempt to hedge economic exposure
3
• •
• • • • • • •
4
Economic exposure—longer term phenomenon wherein the value of a firms foreign operations o Based on costs and revenues in foreign currency o Potentially effected by changes in exchange rates Exchange rates moved rapidly and smoothly to maintain purchasing power parity o Economic exposure would be used not be an issue at all o International law of one price—hold and exchange rates would not matter for international industry PPP does not hold in the short term Longer time—speed of adjustment to PPP can be sporadic—price rigidities and exchange rate changes that are induced more by capital flows than relatively prices of industrial inputs or product prices Crux of economic exposure—risk of protected deviations from PPP—affect the cost structure and competitive position of a multinational firm Hedging the long term consequences of real exchange rate changes—substantially more complicated than hedging either transaction or translation Biggest problem setting up a strategy to hedge economic exposure—firm was so inclined o Estimate the longer term effects of exchange rate changes on the firms cash flow Difficulty assessing effect of exchange rate changes on cash flows—predicting the underlying cause of the exchange rate movement Cannot predict—future exchange rate fluctuations are in line with relative price changes o Forward and futures contracts—standard tools for hedging transaction exposure
