Multinational Financial Management Alan Shapiro 7th Edition J.Wiley

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Multinational Financial Management Alan
Shapiro7th Edition J.Wiley Sons

• Power Points by
• Joseph F. Greco, Ph.D.
• California State University, Fullerton

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CHAPTER 11

• MEASURING AND MANAGING ECONOMIC EXPOSURE

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CHAPTER OVERVIEW

• I. FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
• II. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE
  CHANGES
• III. IDENTIFYING ECONOMIC EXPOSURE
• IV. CALCULATING ECONOMIC EXPOSURE
• V. AN OPERATIONAL MEASURE OF EXCHANGE RISK
• VI. MANAGING OPERATING EXPOSURE

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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 . Expectations about the fluctuation
  must be incorporated in all basic
• decisions of the firm.

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• 2. Definitions
• a. Accounting exposure
• impact on firms balance sheet
• b. Economic exposure
• 1.) Transaction
• 2.) Operating

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• THE REAL EXCHANGE RATE

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FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• B. Real Exchange Rates and Risk
• 1. Nominal v. real exchange rates
• the real rate has been adjusted for price
  changes.

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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 real exchange rate.
• b. It is the relative price changes that
  ultimately determine a firms long-run
  exposure.

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PART II. THE ECONOMIC CONSEQUENCES OF EXCHANGE
RATE CHANGES

• II. ECONOMIC CONSEQUENCES
• A. Transaction exposure
• 1. On-balance sheet
• 2. Off-balance sheet

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THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE
CHANGES

• II. ECONOMIC CONSEQUENCES (cont)
• B. Operating Exposure real rate change
• 1. Pricing flexibility is key
• 2. Product differentiation
• 3. Substitution of inputs

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THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE
CHANGES

• II. SUMMARY
• The sector of the economy in which the
• firm operates
• the sources of the firms inputs
• and
• fluctuations in the real exchange rate
• delineate the firms true economic
• exposure.

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PART III. IDENTIFYING ECONOMIC EXPOSURE

• III. CASE STUDIES OF ECONOMIC EXPOSURE
• A. ASPEN SKIING COMPANY
• 1. Firms exchange rate risk affected its
  sales revenues.

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IDENTIFYING ECONOMIC EXPOSURE

• A. ASPEN SKIING COMPANY (cont)
• 2. Although there was no translation
• risk, the global market with its exchange
  rate risk and its competitors impacted market
  demand.

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IDENTIFYING ECONOMIC EXPOSURE

• B. PETROLEOS MEXICANOS (PEMEX)
• 1. The firms exchange rate risk
• affected cost but not revenues.
• 2. Economic impact
• a. Revenues none
• b. Costs decreased
• c. Net effect increased US flows

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IDENTIFYING ECONOMIC EXPOSURE

• C. TOYOTA MOTOR COMPANY
• 1. Exchange rate risk affected BOTH
• revenues and costs.
• 2. Flow back effect
• previously exported goods return
• with increased domestic competition.
• 3. Lower profit margins domestically

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PART IV. CALCULATING ECONOMIC EXPOSURE

• IV. A quantitative assessment of economic
• exposure depends on underlying assumptions
  concerning
• A. future cash flows
• B. sensitivity to exchange rate
• changes.

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PART V. AN OPERATIONAL MEASURE OF EXCHANGE RISK

• V. NEED FOR A WORKABLE APPROACH
• A. Regression Analysis
• 1. Variables
• a. Independent
• changes in parents cash flows
• b. Dependent
• Average nominal exchange rate change.

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AN OPERATIONAL MEASURE OF EXCHANGE RISK

• B. REGRESSION EQUATION
• -approach based on the operational definition
  of the exchange risk faced by a parent or one of
  its affiliates
• -a company faces exchange risk to the extent
  that variations in the dollar value of the units
  cash flows are correlated with variations in the
  nominal exchange rate

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AN OPERATIONAL MEASURE OF EXCHANGE RISK

• where CFt CFt - CFt-1 and
• CFt is the dollar value of total
  affiliate(parent)cash flows in period t
• EXCHt EXCHt - EXCHt-1 equals the
  average nominal exchange rate during
  period t
• u a random error term

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AN OPERATIONAL MEASURE OF EXCHANGE RISK

• 1. Output measures
• a. Beta coefficient (b)
• measures the association of changes in cash
  flows to exchange rate changes.

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AN OPERATIONAL MEASURE OF EXCHANGE RISK

• b. the higher the percentage change of cash
  flow to changes in exchange rates, the
  greater the economic exposure (higher beta
  values).

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AN OPERATIONAL MEASURE OF EXCHANGE RISK

• VI. SUMMARY
• A. The focus of the accounting profession
  on the balance sheet impact of currency
  changes has led to ignoring the important
  impact on future cash flows.

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AN OPERATIONAL MEASURE OF EXCHANGE RISK

• B. For firms incurring costs and selling
  products in foreign countries, the net effect
  of currency changes may be less important in the
  long run.

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AN OPERATIONAL MEASURE OF EXCHANGE RISK

• C. To measure exposure properly, you must
  focus on inflation-adjusted or real exchange
  rates instead of nominal or actual exchange
  rates.

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AN OPERATIONAL MEASURE OF EXCHANGE RISK

• D. It is difficult in practice to determine
  what the actual economic impact of a currency
  change will be.

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PART VI. MANAGING OPERATING EXPOSURE

• I. INTRODUCTION
• Operating exposure management requires
• long-term operating adjustments.
• A. Real v. Nominal Changes
• 1. Relative price changes
• leads to marketing and/or
• production revisions

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MANAGING OPERATING EXPOSURE

• B. Proactive Marketing and Production
• Initiatives
• 1. Marketing
• market selection
• product strategy
• pricing strategy
• promotional strategy

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MANAGING OPERATING EXPOSURE

• B. Proactive Marketing and Production
• Initiatives (cont)
• 2. Production
• product sourcing
• input mix
• plant location
• raising productivity

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MANAGING OPERATING EXPOSURE

• II. Marketing Management Adjustments
• A. Market Selection
• 1. use advantage to carve out market share
• 2. Market segmentation

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MANAGING OPERATING EXPOSURE

• B. Pricing strategy Expectations critical
• 1. If HC value falls, exporter gains
• competitive advantage by increasing unit
  profitability and market share.
• 2. The higher price elasticity of demand,
  the more currency risk
• the firm faces by product substitution.

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MANAGING OPERATING EXPOSURE

• 3. Following HC depreciation, local
• firm may have much more freedom in its
  pricing.
• C. Promotional Strategy

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MANAGING OPERATING EXPOSURE

• D. Product Strategy
• exchange rate changes may alter
• 1. The timing of new product introductions,
• 2. Product deletion ,
• 3. Product innovation.

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MANAGING OPERATING EXPOSURE

• III. Product Management Adjustments
• product sourcing and plant location are the
  principal variables to manipulate.
• A. Input mix
• B. Shift production among plants
• C. Plant location
• D. Raising productivity

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MANAGING OPERATING EXPOSURE

• IV. Planning For Exchange-Rate Changes
• A. With better planning and more
  competitive options, firms can change
  strategies substantially
• B. before the impact of an currency change
  makes itself felt.
• C. Implication compaction of adjustment
  period following an exchange-rate change.

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MANAGING OPERATING EXPOSURE

• V. Financial Management of Exchange Rate Risk
  Financial managers Role in Marketing and
  Production
• A. Provide local manager with fore-
• casts of inflation and exchange-
• rate changes.
• B. Identify and focus on competitive
  exposure.

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MANAGING OPERATING EXPOSURE

• C. Design the evaluation criteria so that
  operating managers neither
• rewarded or penalized for
• unexpected exchange-rate
• changes.
• D. Estimate and hedge the operating
• exposure after adjustments made.