CHAPTER 11

Measuring and
Managing Economic
Exposure

PART I. FOREIGN EXCHANGE

RISK AND ECONOMIC
EXPOSURE
I.

FOREIGN EXCHANGE RISK

A. Economic exposure
focuses on the impact of currency
fluctuations on firms value.
1 . The most important aspect of
foreign exchange risk management:
Incorporate expectations about the
risk into all basic decisions of the
firm.

FOREIGN EXCHANGE RISK AND

ECONOMIC EXPOSURE
2. Definition:
Economic exposure =
Transaction exposure +
Operating exposure:
arises because currency
fluctuations alter a companys
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. Implications
1. 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 decline in the real value of a
currency:
makes exports and import-competing
goods more competitive
An 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 firms long-run
exposure.

PART II. THE ECONOMIC

CONSEQUENCES OF EXCHANGE
RATE CHANGES
I. ECONOMIC CONSEQUENCES
The impact on Operating Exposure of a
real rate change depends upon:
Pricing flexibility and
1. Price elasticity of demand
2. Degree of product differentiation
3. The Ability to shift production and
the substitution of inputs

If HC Appreciates

Pricing 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 Differentiation
price 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
inputs from other countries
e.g. Japanese car makers in the late
1980s

PART II.MANAGING OPERATING

EXPOSURE
I. INTRODUCTION
Operating exposure management
requires long-term operating adjustments and
the involvement of all departments.

MANAGING OPERATING
EXPOSURE
II.

Marketing Strategy
A. Market Selection:
use competitive advantage to carve
out market share when currency
values change

MANAGING OPERATING
EXPOSURE
B. Pricing strategy: Expectations
critical
1.

2.

If HC depreciates, exporter gains

competitive advantage by
increasing unit profitability or
market share.
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 alter
1.
2.

The timing of new product

introductions,
Product deletion

3.

Product innovations

MANAGING OPERATING
EXPOSURE
III. Product Management
Adjustments
A.

Input mix shop the world

B.
C.
D.

Shift production among plants

Plant relocation
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 managers Role
Structure the firms 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.