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Learning Objectives
To define economic exposure and exchange risk and distinguish between the two To identify the basic factors that determine the forex risk faced by a particular company or project. To calculate economic exposure given a particular exchange rate change and cost/revenue scenarios To describe marketing, production & financial strategies appropriate for coping w/ econ exposure. Contingency plans to cope with forex risk.
P.V. Viswanath
Operating Exposure
Operating Exposure is the firms uncertainty with respect to its future operating cash flows. If PV = present value of a firm, then the firm is exposed to currency risk if PV/e 0. Operating exposure derives from the operating analysis; hence planning for operating exposure involves the interaction of strategies in finance, marketing, purchasing and production.
P.V. Viswanath
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Operating Exposure
In evaluating the impact of an exchange rate change on the firm, we cannot assume that local currency cost and revenue streams remain constant. Measuring the likely exchange gain (loss) by multiplying the pre-devaluation (pre-revaluation) local currency cashflows by the projected devaluation (revaluation) will usually lead to upwardly biased numbers. This is partly because inflation and exchange rate changes are related, as shown by PPP. Also, the firm itself, its competitors and customers have flexibility in terms of the decisions that they make.
P.V. Viswanath
Pricing Flexibility
The key issue for a domestic firm, when the dollar appreciates is its pricing flexibility. Can it maintain its dollar margins both at home and abroad? Can it maintain its dollar price on domestic sales in the face of lower-priced foreign imports? In the case of foreign sales, can the firm raise its foreign currency selling price to preserve its dollar profit margin?
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the devaluation will also help in fending off import competition. the dollar value of local production costs will drop; however, the higher the import content of local inputs, the less dollar production costs will decline.
if the firm can substitute local inputs for imported inputs, it can cope better with the devaluation. if the firm can sell in other markets, it can keep dollar revenues high.
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Operating Exposure
Expected foreign exchange rate changes are not relevant for the definition of operating exposure because management and investors should have already factored this information into their evaluation of anticipated operating results and market value. For example, the forward rate might be used as a the future spot rate estimate in preparing operating budgets. Similarly, expected cash flow to amortize debt should already reflect the international Fisher effect. The level of expected interest and principal payments should be a function of expected exchange rates, rather than existing rates.
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Swedish Krona/DM Exchange Rate uncertainty The uncertainty of future Swedish Krona short-term interest rates (which is related to the demand for cars). German producer price uncertainty
Still, exchange rate uncertainty is very important and is characteristic of the operating exposure of global firms.
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Instruments du Rhone 1
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Instruments du Rhone -- 2
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If the US unit requires funds and the German unit has excess funds, then leading funds owed by the German unit to the US unit or lagging funds owed by the US unit to the German unit has the effect of a loan by the German unit to the US unit with a saving of 110 basis points. If both units have excess funds, it would be profitable to move funds to the US, with an interest differential of 20 basis points (2.9 versus 2.7).
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Risk Sharing
Risk-Sharing is a contractual arrangement in which the buyer and seller agree to share or split currency movement impacts on payments that pass between them. This is worthwhile if the relationship between the two firms is long-term. For example, Ford and Mazda may agree that all purchases by Ford will be made in Japanese yen at the current rate, as long as it is between 115 and 125 yen/$. If the rate falls outside this range, they may agree to share the difference equally. Of course, if the equilibrium rate level changes drastically, the agreement will have to be changed.
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Reinvoicing Centers
A reinvoicing center is a separate corporate subsidiary that manages in one location all transaction exposure from intracompany trade. Effectively, the reinvoicing center centralizes transaction exposure risk, and diversifies the exposure of the parent company to transaction exposure. It need only hedge residual exposure risk. This method releases individual company subsidiaries from having to worry about transaction exposure for intracompany trades. The reinvoicing center can manage intra-affiliate cash flows, including leads and lags of payments.
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Reinvoicing Centers
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Currency Swaps
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Currency Swaps
Accountants in the US treat currency swaps as foreign exchange transactions rather than as debt and treat the obligation to reverse the swap at some later date as a forward exchange contract. Forward exchange contracts can be matched against assets, but they are entered in a firms footnotes rather than as balance sheet items. Hence, both accounting and operating exposures are avoided.
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