ECONOMIC EXPOSURE

-Prepared bySRIJAN SAXENA (4601)RAGHAV BHATNAGAR (4624)AKSHAY KHARBANDA (4627)VINEETH VIJAYAN (4644)

Economic Exposure- Definition

• exposure to fluctuating exchange rates, affecting company's earnings, cash flow and foreign investments.”

• The risks faced by a company that does 

business or holds investments abroad.• includes changes in forex rates or the chance of

foreign countries defaulting on their debt.

• Measures change in value of business resulting from changes in future operating cash flows caused by unexpected exchange rate movement on future volumes, prices and costs.

• Value of the firm:

• Factors determining the degree of economic exposure:– Market structure;– General business conditions– Government policies.

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Measuring Economic Measuring Economic ExposureExposure

REGRESSION EQUATIONREGRESSION EQUATION-approach based on the -approach based on the operational definition of the operational definition of the exchange risk faced by a parent exchange risk faced by a parent or one of its affiliates:or one of its affiliates:

-a company faces exchange risk -a company faces exchange risk to the extent that variations in the to the extent that variations in the dollar value of the unit’s cash dollar value of the unit’s cash flows are correlated with flows are correlated with variations in the nominal variations in the nominal exchange rateexchange rate

The higher is b, the greater the The higher is b, the greater the economic exposure of the economic exposure of the companycompany..

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where ΔCFt = CFt - CFt-1

CFt is the dollar value of total parent cash flows in period t

ΔEXCHt = et - et-1 the change in the nominal exchange

rate during period t u =a random error term

Measuring Economic Exposure

ttt uEXCHaCF

Types of Economic Types of Economic ExposureExposure

Operating Operating ExposureExposure

Transaction Transaction ExposureExposure

Operating ExposureOperating Exposure Operating exposure measures any change in Operating exposure measures any change in

the present value of a firm resulting from the present value of a firm resulting from changes in future operating cash flows caused changes in future operating cash flows caused by any unexpected change in exchange rates.by any unexpected change in exchange rates.

eett’= real rate (inflation adjusted)’= real rate (inflation adjusted)eett = nominal rate = nominal rateiif,,tf,,t = foreign inflation; i = foreign inflation; ih,th,t = home inflation = home inflation

Arises because of currency fluctuations; can Arises because of currency fluctuations; can alter a company’s future operating cash flows. alter a company’s future operating cash flows.

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• Deals with – The firm’s operations over the coming

months and years, and – Its competitive position vis-à-vis other

firms.

• The most crucial and difficult component to manage in foreign exchange (FX) risk.

• A firm faces operating exposure when:– investment in servicing a market

subject to foreign competition– in sourcing goods and inputs abroad.

• Measurement requires a longer-term perspective, so that competitiveness could be affected by exchange rate exchanges.

Case study

• Foster’s Group Limited

global producer and marketer

of alcoholic & non-alcoholic

beverages with core

operations in brewing

and wine.

Company preview…

• total operating revenue - AUD 5.2 billion

• 40 % of revenue generated outside Australia

• 60 % - North America. • Over 40 per cent of assets

located outside Australia, with 80 % in US

• A Market leader FGL holds approximately 55 % share for beer market.

Modus operandi..Modus operandi..

operating exposure management operating exposure management practices. practices.

primary analysis to explain primary analysis to explain alternatives available to company alternatives available to company to manage its operating exposure. to manage its operating exposure.

• operating exposure -sensitivity of future cash flow w.r.t exchange rate by sensitivity analysis.

• operating exposure depends on whether an unexpected change in exchange rates causes

• unanticipated changes in sales• sales prices• operating costs

• these three variables will be used as variables in the scenario for the sensitivity analysis

Base Case

1. company only has exposure to two major foreign currencies euro and US dollar.

2. 92 per cent of the company’s beer sales are in Australia, 4 % in Europe and another 4 % in US

3. For wine sales, 24 % of wine sales in Australia, 16 per cent in Europe and remaining 60 per cent is in the US

4. the overseas sales price is equivalent to the domestic sales price.

Results..

• It is shown that company is sensitive to AUD appreciation with the company’s revenue more sensitive than the cost.

• Without any adjustment on sales volume and foreign currency, sales price the company suffered an economic loss of AUD 566.65

CONCLUSION

• demand is price sensitive. • company will overcome change in

exchange rate if it • increases its sales volume and

adjusts its sales price. • The appropriate strategy to manage

the operating exposure will be to alter product strategy, adjusting price strategy and shifting production among plants.

MANAGING OPERATING EXPOSURE

• Product differentiation & repositioning.

• Pricing Strategy

• Shifting production among plants

• Selecting Low-Cost Production Sites

• Flexible Sourcing Policy

• Diversification of the Market

• R&D Efforts and Product Differentiation

Transaction Exposure

• Risk-exchange rate fluctuations will change the value of a contract before it is settled. – Also called transaction risk. – It is the risk that for-ex rate changes will adversely

affect a cross-currency transaction before it is settled.– Once a cross-currency contract has been agreed upon,

subsequent fluctuations in exchange rates can change the value of that contract.

– A company that has agreed to but not yet settled a cross-currency contract has transaction exposure.

– Greater the time, greater the risk

• For example, – domestic company signs a contract with a foreign

company to ship 1,000 units of product to the foreign company

– Payment: 100 units of foreign currency, to be made in 3 months.

– current exchange rate: 1 unit domestic currency = 1 unit foreign currency.

• The domestic company now has transaction exposure; value of the contract is exposed to the risk of exchange rate fluctuations.

• New exchange rate: 1 unit domestic currency = 2 units foreign currency– New exchange rate remains constant till 3 months.

• Due to the devaluation foreign currency, the foreign company will pay the domestic company only 50 units of domestic currency.

• The contract still stands at 100 units of foreign currency– the domestic firm suffers a 50% loss in value.

Minimizing Transaction Exposure

• Non-Hedging Techniques

•Hedging Techniques

Non-Hedging Techniques

• Transferring exposure– transferring the transaction exposure to another

company • E.g.- A U.S. exporter could quote the sales price of its

product for sale in Germany in dollars, so the German importer faces the transaction exposure

– demand immediate payment, so the spot rate determines the dollar value of export.

• Netting transaction – Unexpected exchange rate charges net out over

many different transactions

• Payments and receipts in multiple currencies

Hedging Techniques

• Forward Market Hedge• Money Market Hedge

– borrow (/lend) in foreign currency to hedge foreign currency receivables (/payables),

• Options Market Hedge– buy a foreign currency call (put) option to hedge

foreign currency payables (receivables)

• Hedging though Invoice Currency– shift, share, or diversify exchange risk by

appropriately choosing the currency of invoice.

Guarding against Economic Guarding against Economic Exposure: Advantage China Exposure: Advantage China

Exports surpluses are key drivers of Exports surpluses are key drivers of Chinese Economy growth.Chinese Economy growth. An upward pressure is put on China’s An upward pressure is put on China’s

currency when its dollar based revenues currency when its dollar based revenues inflows converted to Yuan. inflows converted to Yuan.

This upward pressure would strengthen This upward pressure would strengthen Yuan, making it less competitive at global Yuan, making it less competitive at global stage for trade stage for trade

Chinese central bank manages the value Chinese central bank manages the value of its currency.of its currency.

Till recently, trading of Yuan had been Till recently, trading of Yuan had been heavily restricted by the government — heavily restricted by the government — Most international trade was priced in U.S. dollars Most international trade was priced in U.S. dollars

and settled in U.S. dollars.and settled in U.S. dollars. To offset- the central bank sells Yuan and buy To offset- the central bank sells Yuan and buy

dollars. dollars. keeps the exchange rate stablekeeps the exchange rate stable China builds vast amounts of dollar reservesChina builds vast amounts of dollar reserves

in 2005, it decided to peg Yuan to a basket of in 2005, it decided to peg Yuan to a basket of currencies (USD, EUR, JPY and KRW) instead currencies (USD, EUR, JPY and KRW) instead of the sole USD in the past. of the sole USD in the past.

Since China Since China adopted the adopted the Managed float’ Managed float’ system yuan system yuan climbed by 17% climbed by 17% against USD.against USD.

grossly grossly undervalued, undervalued, compare growth of compare growth of Chinese economy Chinese economy at 43% viz-a-viz US at 43% viz-a-viz US economy at 10% economy at 10% during the same during the same period. period.

Currency Coalition

• euro (€) is the official currency of 16 of the 27 member states of the European Union (EU).

• BENIFITS• removes cost of exchanging currency allowing to

enter in previously unprofitable trades. • removes exchange rate risks. • Companies that hedge against this risk will no

longer need to shoulder this additional cost.

Currency Coalitiondouble edged sword

• recession of 2008 exposed fallacies of unified currency system when countries don’t share same industrial structure and economic health.

• Germany and France have already emerged out of recessionary trend while Italy &others are forced to crawl out at snail’s pace.

spain• Spain is being furthered into a recessionary economy and is close to breaking out into civil war.• The economy used to benefit • when market pressures forced down the local currency:• “In 1992 and 1993 a series of devaluations got us out

of trouble.” Now Spain needs other adjustment mechanisms:

• SPAIN NEEDS TO!!!!!!!!@@@$$@#@• lower wages to restore cost competitiveness to its firms • flexible job market to speed the flow of workers from

industries such as construction to export firms that can generate the revenues to service Spain’s debts.

So what can Spain do?

• It needs to become more competitive — but it cannot have a devaluation, because it is a euro country.

• Next alternative -wage cuts, which are desperately hard to achieve (and create big problems for debtors.)

• <<<Final word>>>• being a member of the Euro Zone doesn’t immunize countries against

crisis. • In Spain’s case (and Italy’s, Ireland’s, and Greece’s) the euro may well be

making things worse.• by exposing themselves to a unified currency weaker economies risk

their primary avenue to pull out of recession or to adjust their budget deficits or trade deficits etc.

•

CONCLUSIONCONCLUSION•At the microeconomic level, economic exposure concerns all firms the moment they are exposed to global competition.

•individual firms through their knowledge of hedging techniques and proper planning of operations can position themselves

•China’s Currency Policy & Undervaluation

•Volatility of Indian Markets

•Value Driven Production

RecommendationsRecommendations RBI should allow rupee to be RBI should allow rupee to be

traded freely but should be traded freely but should be prudent to keep it in a narrow prudent to keep it in a narrow range (for eg. USD/INR 45-48). range (for eg. USD/INR 45-48).

India could device a more India could device a more transparent method of managing transparent method of managing its float, but simultaneously allows its float, but simultaneously allows the trading of rupee, which would the trading of rupee, which would lead to less transaction exposure lead to less transaction exposure for Indian business houses.for Indian business houses.

Internationalisation of exchangesInternationalisation of exchanges Promoting Competition among Promoting Competition among

certain Industries.certain Industries. Common Currency Agreement Common Currency Agreement

Sector Wise Recommendations

IT Sector

•Reduce US dependence

•Diversify manufacturing

•Look for domestic opportunities

•Move up the value chain

Textiles-

Indian exporters should quickly move up the learning curve in currency hedging skills to protect budgeted earnings.

Exporters should also reduce invoicing in dollar terms

Hospitality-

Hospitality industry to offset a negative impact of the rising rupee should become more value driven in terns of security and offerings and other related services.

Automobile Sector-

The Indian government has to back this sector up for surge in exports.

Sufficient investment in R& D to gain a competitive advantage in the global market.