MEASURING ECONOMIC EXPOSURE

1
CHAPTER 10

• MEASURING ECONOMIC EXPOSURE

2
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 Rate Risk

3
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.

4
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

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

5
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• THE REAL EXCHANGE RATE

6
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE

• B. Real Exchange Rates and Risk
• 1. Nominative v. real exchange rates
• real rate has been adjusted for
• price changes.
• 2. Hobsons Choice
• when faced with a change in real value,
• do you keep price constant (changing sales)
  or change prices (change profits)

7
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.

8
PART II. THE ECONOMIC CONSEQUENCES OF EXCHANGE
RATE CHANGES

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

9
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

10
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.

11
PART III. IDENTIFYING ECONOMIC EXPOSURE

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

12
PART III. 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

13
PART III. 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

14
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

15
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.

16
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.

17
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

18
AN OPERATIONAL MEASURE OF EXCHANGE RISK

• where CFt CFt - CFt-1 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

19
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.

20
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).

21
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.

22
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.

23
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.

24
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.