Measuring and Managing Economic Exposure - DOC

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					Finance 4328 (Moore)       Chapter 11 Notes           Summer 2006


           Measuring and Managing Economic Exposure
                          Chapter 11

PART I. FOREIGN EXCHANGE RISK AND ECONOMIC
        EXPOSURE

I.     FOREIGN EXCHANGE RISK
       A. Economic exposure focuses on the impact of currency
          fluctuations on firm’s value.
          1. The most important aspect of foreign exchange risk
             management:
               Incorporate expectations about the risk into all basic
               decisions of the firm.

           2. Definition: Economic exposure =

                Transaction exposure + Operating exposure:

                arises because currency fluctuations alter a company’s
                future revenues and expenses.

       To measure operating exposure requires a longer-term
       perspective.
         i.e. Cost and price competitiveness could be affected by
         exchange rate changes

     Operating Exposure begins:

     The moment a firm starts to invest in a market subject to foreign
     competition or in sourcing goods or inputs abroad.

The new investment includes:
          New product development
          A distribution network
          Brand name development
          Marketing
          Foreign supply contracts
          Production facilities
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Finance 4328 (Moore)       Chapter 11 Notes            Summer 2006


   B. Real Exchange Rates Changes and Risk

          Nominal v. real exchange rates:
            real rate has been adjusted for price changes.

   C. Implications

          1. If nominal rates change with an equal price change, no
             alteration to cash flows.

          2. If real rates change, it causes relative price changes and
             changes in purchasing power.

   A decline in the real value of a currency:
      Makes exports and import-competing goods more competitive.

   An appreciating currency makes:
      Imports and export-competing goods more competitive.

   During an appreciation of home currencies:
      Exporters face two choices:

          - Keep prices constant (but lose sales) or adjust prices to
            foreign currency to maintain market share (lose profits).


   3. SUMMARY
      a. The economic impact of a currency change depends on the
         offset by the difference in inflation rates or the change in real
         exchange rates.

      b. It is the relative price changes that ultimately determine a
         firm’s long-run exposure.




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Finance 4328 (Moore)         Chapter 11 Notes            Summer 2006


PART II. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE
         CHANGES

I.     ECONOMIC CONSEQUENCES
       The impact on Operating Exposure of a real rate change depends
       upon:

          Pricing flexibility and

          1. Price elasticity of demand
          2. Degree of product differentiation
          3. The Ability to shift production and the substitution of inputs


If HC Appreciates

Pricing Flexibility is key

     Can the firm maintain its profit margins both at home and abroad?

     If price elasticity of demand is low, the more price flexibility a firm
     has.
        i.e. Availability of good substitutes

Product Differentiation
       Price elasticity depends on degree of differentiation.

       The greater the differentiation, the more the firm can control its
       prices.

       e.g. Mercedes Benz cars

     The Ability to Shift Production and to source inputs from
     other countries

       e.g. Japanese car makers in the late        1980’s



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Finance 4328 (Moore)       Chapter 11 Notes           Summer 2006
PART III.MANAGING OPERATING EXPOSURE

I. INTRODUCTION
   Operating exposure management requires long-term operating
   adjustments and the involvement of all departments.

II. Marketing Strategy
      A. Market Selection:
          Use competitive advantage to carve out market share when
          currency values change.


   B. Pricing strategy: Expectations critical

      1.     If HC depreciates, exporter gains competitive advantage by
             increasing unit profitability or market share.

      2.     The higher price elasticity of demand, the more currency risk
             the firm faces by other product substitution.


   C. Product Strategy
      Exchange rate changes may alter:

      1. The timing of new product introductions
      2. Product deletion
      3. Product innovations

III. Product Management Adjustments
      A. Input mix “shop the world”
      B. Shift production among plants
      C. Plant relocation
      D. Raising productivity

IV. Planning For Exchange-Rate Changes
      A. Develop contingency plans with plausible scenarios
         before the impact of a currency change makes itself felt.

             e.g. Flexible manufacturing systems

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Finance 4328 (Moore)       Chapter 11 Notes           Summer 2006


V.    Financial Management of Exchange Rate Risk:
      Financial manager’s Role
          Structure the firm’s liabilities in such a way that the
           reduction in asset earnings is matched by corresponding
           decrease in cost of servicing liabilities.

      A.     Provide the local manager with forecasts of inflation and
             exchange-rate changes.

      B.     Identify and focus on competitive   exposure.


      C.     Design the evaluation criteria so that operating managers
             neither rewarded or penalized for unexpected exchange-rate
             changes.




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