CHAPTER 11 Measuring and Managing Economic Exposure.
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Transcript of CHAPTER 11 Measuring and Managing Economic Exposure.
CHAPTER 11
Measuring and Managing Economic
Exposure
PART I. FOREIGN EXCHANGE RISK AND ECONOMIC
EXPOSURE
I. FOREIGN EXCHANGE RISKA. Economic exposure
focuses on the impact of currencyfluctuations on firm’s value.1 . The most important aspect of
foreign exchange risk management:
Incorporate expectations about the Incorporate expectations about the risk into all basic decisions of the risk into all basic decisions of the firm.firm.
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
2. Definition:Economic exposure =
Transaction exposure +
Operating exposure:
arises because currency fluctuations alter a
company’s future revenues and
expenses.
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
To measure operating exposure requires a longer-term perspective.
i.e. Cost and price competitiveness could be affected by exchange rate changes
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
Operating Exposure begins:the moment a firm starts to invest in a market subject to foreign competition or in sourcing goods or inputs abroad
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
The new investment includes:New product development
A distribution network
Brand name development
Marketing
Foreign supply contracts
Production facilities
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
B. Real Exchange Rates Changes and Risk
Nominal v. real exchange rates:
real rate has been adjusted for
price changes.
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
C. Implications1. If nominal rates change with an equal price change, no alteration to cash flows.
2. If real rates change, it causes relative price changes and changes in purchasing power.
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
A declinedecline in the real value of a currency:
makes exports and import-competing goods more competitive
An appreciating appreciating currency makes:
imports and export-competing goods more competitive
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
During an appreciation of home currencies:
Exporters face two choices:
#1 keep prices constant (but lose sales)
or
#2 adjust prices to foreign currency to maintain market share (lose profits)
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
3. SUMMARY
a. the economic impact of a currency change depends on the offset by the difference in inflation rates or the change in real exchange rates.
b. It is the relative price changes that
ultimately determine a firm’s long-run
exposure.
PART II. THE ECONOMIC CONSEQUENCES OF EXCHANGE
RATE CHANGES
I. ECONOMIC CONSEQUENCESThe impact on Operating Exposure of a
real rate change depends upon:
Pricing flexibility and
1. Price elasticity of demand2. Degree of product differentiation
3. The Ability to shift production and
the substitution of inputs
If HC Appreciates
Pricing Flexibility is keyPricing Flexibility is key
If HC Appreciates
Can the firm maintain its profit margins both at home and abroad?
If price elasticity of demand is low, the more price flexibility a firm has.
i.e. Availability of good substitutes
If HC Appreciates
Product DifferentiationProduct Differentiationprice elasticity depends on degree of
differentiation
The greater the differentiation, the more the firm can control its prices.
e.g. Mercedes Benz cars
If HC Appreciates
The Ability to Shift Production and to source The Ability to Shift Production and to source inputs from other countriesinputs from other countries
e.g. Japanese car makers in the late 1980’s
PART II.MANAGING OPERATING EXPOSURE
I. INTRODUCTIONOperating exposure management requires long-term operating adjustments and the involvement of all departments.
MANAGING OPERATING EXPOSURE
II. Marketing StrategyMarketing StrategyA. Market Selection:
use competitive advantage to carve out market share when currency values change
MANAGING OPERATING EXPOSURE
B. Pricing strategy: Expectations critical
1. If HC depreciates, exporter gains
competitive advantage by increasing unit profitability or market share.
2. The higher price elasticity of demand, the more currency risk
the firm faces by other product substitution.
MANAGING OPERATING EXPOSURE
C. Product Strategy
exchange rate changes may alter1. The timing of new product
introductions,
2. Product deletion
3. Product innovations
MANAGING OPERATING EXPOSURE
III. Product Management Adjustments
A. Input mix “shop the world”
B. Shift production among plants
C. Plant relocation
D. Raising productivity
MANAGING OPERATING EXPOSURE
IV. Planning For Exchange-Rate Changes
A. Develop contingency plans
with plausible scenarios
before the impact of a currency change makes itself felt.
e.g. flexible mfg systems
MANAGING OPERATING EXPOSURE
V. Financial Management of Exchange Rate Risk:
Financial manager’s RoleFinancial manager’s Role
Structure the firm’s liabilities in such a way that the reduction in asset earnings is matched by corresponding decrease in cost of servicing liabilities.
MANAGING OPERATING EXPOSURE
A. Provide local manager with
forecasts of inflation and exchange-rate changes.
B. Identify and focus on competitive exposure.
MANAGING OPERATING EXPOSURE
C. Design the evaluation criteria so that operating managers neither
rewarded or penalized for unexpected exchange-rate changes.