Assessing Exchange Rate RiskII

8/3/2019 Assessing Exchange Rate RiskII

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Assessing Exchange RateAssessing Exchange Rate

Risk: Part IIRisk: Part II

Exchange Rate ExposureExchange Rate Exposure


2/28

www.blades.com

BLADES Board & Skate arrived on the

action / extreme scene in 1990, andquickly became a trusted source of

equipment and service to in-line skaters,

skateboarders, and snowboarders.

BLADES got its start in New York and currently

operates 15 retail stores in New York, New Jersey,

Massachusetts and Pennsylvania.
http://www.blades.com/http://www.blades.com/home/index.jsphttp://www.blades.com/product/index.jsp?productId=1879645&cp=760780http://www.blades.com/product/index.jsp?productId=1831782&cp=698499http://www.blades.com/


3/28

Increasing competition

and rising costs have

lowered Blades profitmargins

Blades could cut costs byimporting lower cost

components from Thailand
http://www.blades.com/home/index.jsp


4/28

Suppose that Blades makes an agreement to buy plastic

components sufficient to produce 72,000 pairs of

rollerblades from Thai manufacturers at a price ofTHB2,870 per pair. ($1 = THB 38.87). Payment is due in one

month (72,000*2,870 = THB 206.64 M)

Trend


5/28

THB 2,870 per pair

(THB 1 =

$ .0257)

Should Blades import components from

Thailand?

$75 Per Pair

THB 2,870 (.0257) = $73.75

$75 - $73.75

$75

100 = 1.6%

At the current

exchange rate,

Blades could cut

their costs by 1.6%by importing from

Thailand (a savings

of $90,000)!!


6/28

However, importing Thai components

creates a transaction exposure for Blades

THB 2,870 per pair

(THB 1 = $ .0257)

Costs ($) = e ($/THB) * 72,000* Costs (THB)

ConstantsRandom

Variable

We need to

estimate this!!


7/28

Regression Results

Variable Coefficients Standard Error t Stat

Intercept . 80 .02 40

Inflation .80 .35 2.28

Regression Statistics

R Squared .43

Standard Error 2.20

Observations 240

( ) ++= *% bae

Every 1% difference between US inflation and Thai

inflation depreciates the dollar by .8%


8/28

US inflation is currently 1% (per month) while

inflation in Thailand is 2.25% (per month)

=.8 + 0.80 * (inf) + error

(1 2.25) = -1.25

Mean = . 80

Std. Dev. = .02

Mean = .80

Std. Dev. = . 35

Mean = 0

Std. Dev. = 2.20

Forecast

Mean = -.2%

Std. Dev. = 2.25%

%25.2)20.2()25.1()35(.)02(. 2222 =++=StdDev

Your 95% confidence

interval for the (monthly)

percentage change in the

exchange rate is

[-4.7% , 4.3% ]

% Change in e

($/THB)


9/28

Forecast (% Change)Mean = -.2%

Std. Dev. = 2.25%

Assessing transaction exposure

Costs ($) = e ($/THB) * 72,000*2,870 THB

THB 2,870 per pair

(THB 1 =

$ .0257)

CostsMean = 72,000*2,870*.0257(1-.002)

= $5,300,026

Std. Dev. = .0225*72000*2870*.0256

= $119,250 (2.25%)


10/28


Costs ($) = e ($/THB) * 72,000*2,870 THB

You are 95% sure your costs will

be between:

$5,300,026 + 2*$119,250 = $5,538,526

and$5,300,026 - 2*$119,250 = $5,061,526

THB 2,870 per pair

(THB 1 =

$ .0257)

Mean = $5,300,026Std. Dev. = $119,250


11/28

THB 2,870 per pair

(THB 1 =

$ .0257)

Should Blades import components from

Thailand?

$75 Per Pair

Mean = $5,300,026

Std. Dev. = $119,250

Mean = $5,400,000

Std. Dev. = $0

What do you do?


12/28

Blades is also thinkingabout exporting

rollerblades to Thailand


13/28

Suppose that Blades makes an agreement to sell 30,000

pairs of roller blades to a Thai sporting goods store for

THB 4,500 apiece.

Trend


14/28

Forecast (% Change)Mean = -.2%

Std. Dev. = 2.25%


Net Cash Flows($) = e ($/THB) * ( 72,000*2,870 - 30,000*4,500)

Net Cash Flows($)Mean = 71,640,000*.0257(1-.002)

= $1,837,465

Std. Dev. = .0225*71,640,000*.0257

= $41,342 (2.25%)

= e ($/THB) * ( 71,640,000THB)


15/28

Blades could also import

Japanese components.Japanese components are

slightly more expensive

(Y 8,000 per pair = $74.77)

$1 = Y 107


16/28

Suppose that Blades splits its purchases

of components between Thailand and

Japan (Exports to Thailand = 0)

THB 2,870 per pair

(THB 1

= $ .0257)

JPY 8,000 per pair

(JPY 1 = $ .0093)

THB 2,870*.0257*36,000 = $2,655,324

JPY 8,000*.0093*36,000 = $2,678,400

$5,333,724


17/28

$2,678,400$5,333,724

Forecast (% Change)

Mean = 0%

Std. Dev. = 2.25%

Forecast (% Change)

Mean = 0%

Std. Dev. = 3.50%

$2,655,324$5,333,724

= .49 = .51

CORR = -.65

Net Cash Flows

( ) ( ) %4.1014.)65.)(035)(.0225)(.51)(.49(.2)035(.)51(.0225.49.

724,333,5$

2222==++=

=

SD

Mean


18/28

Cash flow Situation And the Currenciesare

Currencyexposure

Equal Inflows of Two Currencies Positively Correlated High

Equal Inflows of Two Currencies Uncorrelated Moderate

Equal Inflows of Two Currencies Negatively Correlated Low

Inflow in one currency/outflow inanother

Positively Correlated Low


Uncorrelated Moderate


Negatively Correlated High

Importing from both Japan and Thailand can diversify

currency exposure!!


19/28

Suppose that Blades is planning to expand sales into

England. Should they try and contract sales in dollars

or Pounds?Current

GBP 1 = $1.80

Forecast (% Change)

Mean = 0

SD = 2.0%

Contracting sales in GBP creates transaction

exposure. However, contracting sales in USD creates

economic exposure


20/28

Suppose that Blades agrees to sell roller blades

to England for $125 apiece. (GBP 70)

Current

GBP 1 = $1.80

Forecast (% Change)

Mean = 0

SD = 2.0%

Demand in England is as follows:

Q = 400 - 3P

P = Local price of

Roller blades

At a local price of GBP 70, demand equal 500 - 3(70) = 190


21/28

11.1190

703 =

=

=d

dd

Q

P

P

Q

Elasticity of Demand refers to

the responsiveness of demand

to price changes (here, the price

is the interest rate)

Q = 500 3P

# Roller Blades

P

190

70

d

dd

d

dd

QP

PQ

P

PQ

Q

PQ

=

=

=%%

1%

1.1%


22/28

Suppose that Blades agrees to sell roller blades

to England for $125 apiece. (GBP 70)

Current

GBP 1 = $1.80

Forecast (% Change)

Mean = 0

SD = 2.0%

Revenues = Price ($) * Quantity

ConstantForecast (% Change)

Mean = 0

SD = 2.0%*Elasticity = 2.2%


23/28

Revenues = Price ($) * Quantity

ConstantForecast (% Change)

Mean = 0

SD = 2.0%*Elasticity = 2.2%

Revenues = e ($/L)* Price (L) * Quantity

Constant

Forecast (% Change)

Mean = 0

SD = 2.0

GBP Pricing (Transaction Exposure)

USD Pricing (Economic Exposure)


24/28

Changes in currency prices can have all kinds of

economic impacts. A more general way to estimate

economic exposure would be as follows:

ttt beaPCF ++=

Percentage change in theexchange rate ($/F)

Percentage change in cashflows (measured in home

currency)


25/28

Regression Results

Variable Coefficients Standard Error t Stat

Intercept .05 1.5 .03

% Change inExchange Rate

-3.35 .97 -3.45

Regression Statistics

R Squared .63

Standard Error 1.20

Observations 1,000

++= tt beaPCF

Every 1% depreciation in the dollar relative to the British

pound lowers cash flows from England by 3.35%


26/28

Suppose that Blades sets up a Thai

subsidiary. The Thai plant uses

locally produced components toproduce roller blades that will be

sold to local (Thai) customers.

Is Blades still exposed to currency risk?

Blades ill need to prod ce consolidated cash flo and income


27/28

Blades will need to produce consolidated cash flow and income

statements as well as a consolidated balance sheet. Translation

exposure refers to the impact of exchange rate changes on these

financial statements.

FASB Rule #52 (for US Based MNCs)

The functional currency of an entity is the currency of the economic

environment in which the entity operates

The current exchange rate as of the reporting date is used to translate

assets/liabilities from the functional currency to the reporting currency

The weighted average exchange rate over the relevant reporting period

is used to translate revenues, expenses, gains, and losses

Translated Gains/Losses are not recognized as current net income, but

are reported as a second component of stockholders equity

Should we be worried about this type of

exposure??


28/28

Examples of translation

exposure

Companyompany Citigroupitigroup GeneraleneralMotorsotors Wall Martall MartNet Income (2004)Net Income (2004) $17.04B$17.04B $3.8B$3.8B $9B$9B

Income Gains/LossesIncome Gains/Losses

due to currencydue to currencychangeschanges

$731M$731M

(4.3%)(4.3%)

$929M$929M

(24%)(24%)

$320M$320M

(3.5%)(3.5%)

Assessing Exchange Rate RiskII

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