INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
12Chapter TwelveManagement of Economic Exposure
Chapter Objectives:
This chapter provides a way to measure economic
exposure,discusses its determinants,and presents
methods for managing and hedging economic
exposure.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-1
Chapter Outline
? Three Types of Exposure
? How to Measure Economic Exposure
? Operating Exposure,Definition
? An Illustration of Operating Exposure
? Determinants of Operating Exposure
? Managing Operating Exposure
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-2
? Economic Exposure
? Exchange rate risk as applied to the firm’s competitive
position.
? Transaction Exposure
? Exchange rate risk as applied to the firm’s home
currency cash flows,The subject of Chapter 13.
? Translation Exposure
? Exchange rate risk as applied to the firm’s consolidated
financial statements,The subject of Chapter 14
Three Types of Exposure
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-3
How to Measure
Economic Exposure
? Economic exposure is the sensitivity of the future
home currency value of the firm’s assets and
liabilities and the firm’s operating cash flow to
random changes in exchange rates.
? There exist statistical measurements of sensitivity.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-4
How to Measure
Economic Exposure
? If a U.S,MNC were to run a regression on the
dollar value (P) of its British assets on the dollar
pound exchange rate,S($/￡),the regression would
be of the form:
eSbaP ????
Where a is the regression constant and e is the
random error term with mean zero,The regression
coefficient b measures the sensitivity of the dollar
value of the assets (P) to the exchange rate,S,
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-5
How to Measure
Economic Exposure
The exposure coefficient,b,is defined as follows:
)V a r (
),C o v (
S
SPb ?
Where Cov(P,S) is the covariance between the dollar
value of the asset and the exchange rate,and Var(S)
is the variance of the exchange rate.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-6
How to Measure
Economic Exposure
The exposure coefficient shows that there are two
sources of economic exposure,the the variance of
the exchange rate and the covariance between the
dollar value of the asset and exchange rate.
)V a r (
),C o v (
S
SPb ?
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-7
Operating Exposure,Definition
? The effect of random changes in exchange rates
on the firm’s competitive position,which is not
readily measurable.
? A good definition of operating exposure is the
extent to which the firm’s operating cash flows are
affected by the exchange rate.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-8
An Illustration of
Operating Exposure
? Recently,there was an enormous shortage in the
shipping market from Asia,due to the Asian
currency crisis.
? This affected not only the shipping companies,
which enjoyed,boom times”.
? But also retailers,who experienced increased
costs and delays.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-9
An Illustration of
Operating Exposure
? Note that the exposure for the retailers has two
components:
?The Competitive Effect
?Difficulties and increased costs of shipping.
?The Conversion Effect
?Lower dollar prices of imports due to foreign currency
exchange rate depreciation.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-10
Determinants of Operating Exposure
? Recall that operating exposure cannot be readily
determined from the firm’s accounting statements
as can transaction exposure.
? The firm’s operating exposure is determined by:
?The firm’s ability to adjust its markets,product mix,
and sourcing in response to exchange rate changes.
?The market structure of inputs and products,how
competitive or how monopolistic the markets facing the
firm are.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-11
Managing Operating Exposure
? Selecting Low Cost Production Sites
? Flexible Sourcing Policy
? Diversification of the Market
? R&D and Product Differentiation
? Financial Hedging
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-12
Selecting Low Cost
Production Sites
? A firm may wish to diversify the location of their
production sites to mitigate the effect of exchange
rate movements.
?e.g,Honda built North American factories in response
to a strong yen,but later found itself importing more
cars from Japan due to a weak yen.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-13
Flexible Sourcing Policy
? Sourcing does not apply only to components,but
also to,guest workers”.
?e.g,Japan Air Lines hired foreign crews to remain
competitive in international routes in the face of a strong
yen,but later contemplated a reverse strategy in the face
of a weak yen and rising domestic unemployment.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-14
Diversification of the Market
? Selling in multiple markets to take advantage of
economies of scale and diversification of
exchange rate risk.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-15
R&D and Product Differentiation
? Successful R&D that allows for
? cost cutting
? enhanced productivity
? product differentiation.
? Successful product differentiation gives the firm
less elastic demand—which may translate into less
exchange rate risk.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-16
Financial Hedging
? The goal is to stabilize the firm’s cash flows in the
near term.
? Financial Hedging is distinct from operational
hedging.
? Financial Hedging involves use of derivative
securities such as currency swaps,futures,
forwards,currency options,among others.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-17
End Chapter Twelve
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
12Chapter TwelveManagement of Economic Exposure
Chapter Objectives:
This chapter provides a way to measure economic
exposure,discusses its determinants,and presents
methods for managing and hedging economic
exposure.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-1
Chapter Outline
? Three Types of Exposure
? How to Measure Economic Exposure
? Operating Exposure,Definition
? An Illustration of Operating Exposure
? Determinants of Operating Exposure
? Managing Operating Exposure
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-2
? Economic Exposure
? Exchange rate risk as applied to the firm’s competitive
position.
? Transaction Exposure
? Exchange rate risk as applied to the firm’s home
currency cash flows,The subject of Chapter 13.
? Translation Exposure
? Exchange rate risk as applied to the firm’s consolidated
financial statements,The subject of Chapter 14
Three Types of Exposure
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-3
How to Measure
Economic Exposure
? Economic exposure is the sensitivity of the future
home currency value of the firm’s assets and
liabilities and the firm’s operating cash flow to
random changes in exchange rates.
? There exist statistical measurements of sensitivity.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-4
How to Measure
Economic Exposure
? If a U.S,MNC were to run a regression on the
dollar value (P) of its British assets on the dollar
pound exchange rate,S($/￡),the regression would
be of the form:
eSbaP ????
Where a is the regression constant and e is the
random error term with mean zero,The regression
coefficient b measures the sensitivity of the dollar
value of the assets (P) to the exchange rate,S,
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-5
How to Measure
Economic Exposure
The exposure coefficient,b,is defined as follows:
)V a r (
),C o v (
S
SPb ?
Where Cov(P,S) is the covariance between the dollar
value of the asset and the exchange rate,and Var(S)
is the variance of the exchange rate.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-6
How to Measure
Economic Exposure
The exposure coefficient shows that there are two
sources of economic exposure,the the variance of
the exchange rate and the covariance between the
dollar value of the asset and exchange rate.
)V a r (
),C o v (
S
SPb ?
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-7
Operating Exposure,Definition
? The effect of random changes in exchange rates
on the firm’s competitive position,which is not
readily measurable.
? A good definition of operating exposure is the
extent to which the firm’s operating cash flows are
affected by the exchange rate.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-8
An Illustration of
Operating Exposure
? Recently,there was an enormous shortage in the
shipping market from Asia,due to the Asian
currency crisis.
? This affected not only the shipping companies,
which enjoyed,boom times”.
? But also retailers,who experienced increased
costs and delays.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-9
An Illustration of
Operating Exposure
? Note that the exposure for the retailers has two
components:
?The Competitive Effect
?Difficulties and increased costs of shipping.
?The Conversion Effect
?Lower dollar prices of imports due to foreign currency
exchange rate depreciation.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-10
Determinants of Operating Exposure
? Recall that operating exposure cannot be readily
determined from the firm’s accounting statements
as can transaction exposure.
? The firm’s operating exposure is determined by:
?The firm’s ability to adjust its markets,product mix,
and sourcing in response to exchange rate changes.
?The market structure of inputs and products,how
competitive or how monopolistic the markets facing the
firm are.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-11
Managing Operating Exposure
? Selecting Low Cost Production Sites
? Flexible Sourcing Policy
? Diversification of the Market
? R&D and Product Differentiation
? Financial Hedging
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-12
Selecting Low Cost
Production Sites
? A firm may wish to diversify the location of their
production sites to mitigate the effect of exchange
rate movements.
?e.g,Honda built North American factories in response
to a strong yen,but later found itself importing more
cars from Japan due to a weak yen.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-13
Flexible Sourcing Policy
? Sourcing does not apply only to components,but
also to,guest workers”.
?e.g,Japan Air Lines hired foreign crews to remain
competitive in international routes in the face of a strong
yen,but later contemplated a reverse strategy in the face
of a weak yen and rising domestic unemployment.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-14
Diversification of the Market
? Selling in multiple markets to take advantage of
economies of scale and diversification of
exchange rate risk.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-15
R&D and Product Differentiation
? Successful R&D that allows for
? cost cutting
? enhanced productivity
? product differentiation.
? Successful product differentiation gives the firm
less elastic demand—which may translate into less
exchange rate risk.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-16
Financial Hedging
? The goal is to stabilize the firm’s cash flows in the
near term.
? Financial Hedging is distinct from operational
hedging.
? Financial Hedging involves use of derivative
securities such as currency swaps,futures,
forwards,currency options,among others.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
12-17
End Chapter Twelve
