ManagementofEconomicExposureChapterNineCopyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ChapterOutlineHowtoMeasureEconomicExposureOperatingExposure:DefinitionIllustrationofOperatingExposureDeterminantsofOperatingExposureManagingOperatingExposureSummary9-2Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.EconomicExposureChangesinexchangeratescanaffectnotonlyfirmsthataredirectlyengagedininternationaltradebutalsopurelydomesticfirms.Furthermore,changesinexchangeratesmayaffectnotonlytheoperatingcashflowsofafirmbyalteringitscompetitivepositionbutalsodollar(homecurrency)valuesofthefirm’sassetsandliabilitiesExchangeratechangescansystematicallyaffectthevalueofthefirmbyinfluencingitsoperatingcashflowsaswellasthedomesticcurrencyvaluesofitsassetsandliabilities9-3Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ExchangeRateExposureofU.S.IndustryPortfolios9-4Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.HowtoMeasureEconomicExposureCurrencyrisk(oruncertainty)representsrandomchangesinexchangerates,whilecurrencyexposuremeasures“whatisatrisk”Exposuretocurrencyriskcanbeproperlymeasuredbythefollowing:Sensitivityofthefuturehomecurrencyvaluesofthefirm’sassetsandliabilitiestorandomchangesinexchangeratesSensitivityofthefirm’soperatingcashflowstorandomchangesinexchangerates9-5Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ChannelsofEconomicExposure

9-6Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.MeasuringAssetExposureFromtheperspectiveofaU.S.firmthatownsanassetinBritain,theexposurecanbemeasuredbythecoefficient(b)inregressingthedollarvalue(P)oftheBritishassetonthedollar/poundexchangerate(S)P=a+b×S+eWhere

aistheregressionconstanteistherandomerrortermwithmeanzerotheregressioncoefficientbmeasuresthesensitivityofthedollarvalueoftheasset(P)totheexchangerate(S)9-7Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.MeasuringAssetExposure(Continued)Theexposurecoefficient,b,isdefinedasfollows:WhereCov(P,S)isthecovariancebetweenthedollarvalueoftheassetandtheexchangerateVar(S)isthevarianceoftheexchangerateCov(P,S)Var(S)b=9-8Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ExampleSupposeaU.S.firmhasanassetinBritainwhoselocalcurrencypriceisrandom.Forsimplicity,supposethereareonlythreestatesoftheworldandeachstateisequallylikelytooccur.ThefuturelocalcurrencypriceofthisBritishasset(P*)aswellasthefutureexchangerate(S)

willbedetermined,dependingontherealizedstateoftheworld.9-9Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.MeasurementofCurrencyExposure9-10Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ComputationsofRegressionParameters:Case19-11Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.HedgingAssetExposureOncethemagnitudeoftheexposureisknown,thefirmcanhedgetheexposurebysimplysellingtheexposureforwardWecandecomposethevariabilityofthedollarvalueoftheasset,Var(P),intotwoseparatecomponents:exchangerate-relatedandresidualConsequencesofhedgingtheexposurebyforwardcontractsareillustratedinthenextslide9-12Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ConsequencesofHedgingCurrencyExposure9-13Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.OperatingExposure:DefinitionManymanagersdonotfullyunderstandtheeffectofvolatileexchangeratesonoperatingcashflowsOperatingexposureistheextenttowhichthefirm’soperatingcashflowswillbeaffectedbyrandomchangesintheexchangeratesInmanycases,operatingexposuremayaccountforalargerportionofthefirm’stotalexposurethancontractualexposure9-14Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.IllustrationofOperatingExposure“SupposeaU.S.computercompanyhasawhollyownedBritishsubsidiary,AlbionComputersPLC,thatmanufacturesandsellsPCsintheU.K.market.AlbionComputersimportsmicroprocessorsfromIntel,whichsellsthemfor$512perunit.Atthecurrentexchangerateof$1.60perpound,eachIntelmicroprocessorcosts￡320.AlbionComputershiresBritishworkersandsourcesalltheotherinputslocally.Albionfacesa50percentincometaxrateintheU.K.”9-15Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ProjectedOperationsforAlbionComputersPLC:BenchmarkCase($1.60/)9-16Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.IllustrationofOperatingExposure(Continued)ConsiderthepossibleeffectofadepreciationofthepoundontheprojecteddollaroperatingcashflowofAlbionComputers.Assumethepoundmaydepreciatefrom$1.60to$1.40perpoundThedollaroperatingcashflowmaychangefollowingapounddepreciationdueto:CompetitiveeffectConversioneffect9-17Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.IllustrationofOperatingExposure(Concluded)Considerthefollowingcaseswithvaryingdegreeofrealism:Case1:Novariableschange,exceptthepriceoftheimportedinput.Case2:Thesellingpriceaswellasthepriceoftheimportedinputchanges,withnootherchanges.Case3:Allthevariableschange.9-18Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ProjectedOperationsforAlbionComputersPLC:Case1($1.40/￡)9-19Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ProjectedOperationsforAlbionComputersPLC:Case2($1.40/￡)9-20Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ProjectedOperationsforAlbionComputersPLC:Case3($1.40/￡)9-21Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.SummaryofOperatingExposureEffectofPoundDepreciationonAlbionComputers9-22Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.DeterminantsofOperatingExposureOperatingexposurecannotbereadilydeterminedfromthefirm’saccountingstatements,unliketransactionexposureAfirm’soperatingexposureisdeterminedby:Thestructureofthemarketsinwhichthefirmsourcesitsinputs,suchaslaborandmaterials,andsellingitsproductsThefirm’sabilitytomitigatetheeffectofexchangeratechangesbyadjustingitsmarkets,productmix,andsourcing9-23Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.DeterminantsofOperatingExposure(Continued)AfirmisusuallysubjecttohighdegreesofoperatingexposurewheneitheritscostoritspriceissensitivetoexchangeratechangesWhenboththecostandthepricearesensitiveorinsensitivetoexchangeratechanges,thefirmhasnomajoroperatingexposureTheextenttowhichafirmissubjecttooperatingexposuredependsonthefirm’sabilitytostabilizecashflowsinthefaceofexchangeratechanges9-24Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ManagingOperatingExposureObjectiveofmanagingoperatingexposureistostabilizecashflowsinthefactoffluctuatingexchangeratesFirmsmayusethefollowingstrategiesformanagingoperatingexposure:Selectinglow-costproductionsitesFlexiblesourcingpolicyDiversificationofthemarketProductdifferentiationandR&DeffortsFinancialhedging9-25Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.SelectingLowCostProductionSitesWhenthedomesticcurrencyisstrongorexpectedtobecomestrong,afirmmaychoosetolocateproductionfacilitiesinaforeigncountrywherecostsarelowLowcostsmaybeduetoeithertheundervaluedcurrencyorunderpricedfactorsofproductionThefirmmaychoosetoestablishandmaintainproductionfacilitiesinmultiplecountriestodealwiththeeffectofexchangeratechangesExample:NissanhasmanufacturingfacilitiesintheU.S.,U.K.,andMexico,aswellasJapan9-26Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.FlexibleSourcingPolicyEvenifafirmhasmanufacturingfacilitiesonlyinthedomesticcountry,itcansubstantiallylessentheeffectofexchangeratechangesbysourcingfromwhereinputcostsarelowExample:Intheearly1980swhenthedollarwasverystrongagainstmostmajorcurrencies,U.S.multinationalfirmsoftenpurchasedmaterialsandcomponentsfromlow-costforeignsuppliersFlexiblesourcingpolicyisastrategyformanagingoperatingexposurethatinvolvessourcingfromareaswhereinputcostsarelow9-27Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.DiversificationoftheMarketDiversifyingthemarketforthefirm’sproductsisanotherwaytomanagingexchangeexposureExample:IfGEissellingpowergeneratorsinMexicoandGermany,reducedsalesinMexico(duetothedollarappreciationagainstthepeso)couldbecompensatedbyincreasedsalesinGermany(duetothedollardepreciationagainsttheeuro)Notethatexpansionintoanewbusinessshouldbejustifiedonisownright,nots