ECONOMIC EXPOSURE

Multinational
M li i l Financial
Fi i l Management;
M Alan
Al Shapiro
Sh i
International Financial Management; Eun & Resnick
International Financial Management: Jeff Madura
ECONOMIC EXPOSURE
Economic exposure is concerned with impact of
changes in exchange rates on the
Value of the firm referred as Economic Exposure
C h flflows off th
Cash the fifirm referred
f d as O
Operating
ti
Exposure
E
Economici exposure refers
f tto unanticipated
ti i t d
change in the value of firm. Anticipated changes
are already
l d di discounted
t d iin th
the stock
t k price.
i

Rajiv Srivastava Economic Exposure 2

IT EFFECTS ALL
Appreciation/depreciation
/ off the local currency has
impact on all firms irrespective of their national status
(MNC or domestic).
All firms face competition: domestic as well as foreign
firms/products.
Change in exchange rate alters the competitive position
of the firm due to change in prices of the product from
foreign suppliers.
suppliers
The degree of impact will be different for different firms
depending
p g upon:
p
Reliance on inputs/outputs from foreign suppliers

Level of competition from foreign products.

Rajiv Srivastava Economic Exposure 3

DIFFERENCES
Distinct from transaction exposure: results from the fixed
contract obligations denominated in foreign currency.
P
Pure d
domestici fifirms d
do not h
have translation
l i andd
transaction exposures but do have economic exposure.
If rupee depreciates: Domestic firms face less
competition from foreign products as they become
relatively
y dearer
If rupee appreciates: More competition as foreign
products become relatively cheaper.
For MNCs the degree of economic exposure is relatively
high as compared to domestic firm.

Rajiv Srivastava Economic Exposure 4

DIFFERENCES
TRANSACTION ECONOMIC
Contract specific Economy specific
Relates to transaction Relates to opportunity
cost cost
Tactical Strategic
Concerns changes in Concerns changes in
nominal exchange rates real exchange rates

Rajiv Srivastava Economic Exposure 5

REAL vs NOMINAL
Changes in nominal exchange rate are
immaterial for economic exposure. The
change
h iin reall exchange
h rate
t causes
economic exposure.
Any change in exchange rate consistent
with inflation rates should have no impact
p
on the relative competitive position of the
p
firm with respect to foreign
g competition.
p
If PPP holds the real exchange rate
remains constant.
constant
Rajiv Srivastava Economic Exposure 6
REAL vs. NOMINAL
Assume rupee is devalued by 5% and inflation
rates in India and UK are 3% and 2%
respectively. If nominal exchange rate was F0 the
nominal rate at the end of 1 year shall be 0.95 F0.
The real exchange rate is given by
1 + Id 1.03
Reall E
R Exchange
h Rate
R t F' = F = 0.95
0 95 F0 = 0.96
0 96 F0
1 + If 1.02

Where F = Nominal Exchange Rate

Id and If are domestic and foreign country inflation rates

Rajiv Srivastava Economic Exposure 7

REAL RATES MATTER
US firm has an Indian subsidiary currently earning Rs
Rs.
4,500 equivalent to $ 100 at current exchange rate of Rs.
45/$.
Inflation in India and USA are 10% and 0% respectively.
As per PPP the exchange rate after a year will be Rs.
49 50/$ (Rupee depreciating by 10%)
49.50/$
Now A year later
Sales in Rupees 14,500 15,950
Cost in Rupees 10,000 11,000
Profit 4,500 4,950
E i l t$
Equivalent 100 100
All sales and cost will increase in India by 10% and so will
the profit. Position of US parent remains unaffected.
Rajiv Srivastava Economic Exposure 8
FIXED RATE NO SOLUTION
Exchange Rate pegged to a currency (China)
Would it cause economic exposure?
E
Exporter
t from
f China
Chi (fixed
(fi d rate
t Yuan
Y 8/$) Inflation
I fl ti
5% in China 0% in USA
N
Now L t
Later
Selling Price $ 10 Yuan 80 Yuan 80
C t iin Y
Cost Yuan 40 42
Profit 40 38
Profit
P fit d
declines
li b
by 5%
5%. Th
The reall rate
t changes
h b
by
5% devaluation of Yuan even though the nominal
rate remains same
same.
Rajiv Srivastava Economic Exposure 9
MEASURING ECONOMIC EXPOSURE

Measure the sensitivity of cash flow with respect

to exchange rate
rate.
Operating cash flows, Assets and Liabilities all
change
h th
the value
l off th
the fi
firm.
Impact on operating cash flows: Operating exposure
Impact on assets and liabilities: Economic exposure
Most people regard both as same

Rajiv Srivastava Economic Exposure 10

SCENARIO & REGRESSION
Scenario Analysis:
forecast changes in cash flows with changing
exchange rates
classify items of revenue and expenses and
project subjectively the cash flows with varying
exchange rate scenario.
Do a regression analysis
R=a+bF+e
R = Value of cash flow
flow,
F = Exchange rate,
a, b are regression
g coefficients, and e = error

Rajiv Srivastava Economic Exposure 11

REGRESSION
What can be hedged:
R=a+bF+e
Var ((R)) = b2 Var ((F)) + Var ((e))

Part of variability due to Part of variability not

random
ndom changes
h nge in the dependent upon
pon
exchange rates exchange rate
(can be hedged) (Cannot be hedged)

Rajiv Srivastava Economic Exposure 12

MANAGING ECONOMIC EXPOSURE

Marketing
Diversifying markets
Pricing strategy
Product differentiation
Production
Input mix
Shifting production
Plant Locations
Raising productivity
Financial
Rajiv Srivastava Economic Exposure 13
MANAGING ECONOMIC EXPOSURE
N t tto manage att all
Not ll because:
b E
Economic
i hhedge
d iis
superset of transaction exposure, so manage transaction
exposure well to mange economic exposure.
Financial hedge:
Advantage:
Marketing and Production related hedges are extremely
strategic.
Financial hedge is easy to implement, Forward, futures and
options provide easy solutions
Di d
Disadvantage:
t
amounts to taking a speculative position in FE market.

converts economic exposure to transaction exposure

exposure.
Rajiv Srivastava Economic Exposure 14
FINANCIAL HEDGE -
FORWARD CONTRACT
Cov(R , F) p(R R )(F F )
C ffi i t
B t Coefficien
Beta
Var (F) p(F F ) 2

Scenario Prob $ Cash flow Ex Rate R

1 1/3 1,000 45 45,000

2 1/3
/ 1,100
, 46 50,600
,
3 1/3 1,200 47 56,400
Average 46 50,667

Var (F) = 1/3{(45 - 46)2+(46 - 46)2+(47 - 46)2} = 2/3

Cov (R,F)
(R F) = 1/3{(45,000
1/3{(45 000 50,667)(45
50 667)(45 46) + (50,600
(50 600
50,667)(46 46) +(56,400 50,667)(47 46)}
= 11,400/3 = 3,800
B t coefficient
Beta ffi i t = 3,800/2/3=
3 800/2/3 5,700
5 700
Rajiv Srivastava Economic Exposure 15
 FORWARD CONTRACT
& ECONOMIC EXPOSURE

One rupee change in exchange rate effects the

cash flow by RsRs. 5
5,700.
700 Depreciation of rupee
leads to increased cash flow while appreciation
reduces the cash flow.
Protection required against appreciation of rupee
((depreciation
p of $)
THE STRATEGY:
Sell $ forward equivalent to beta coefficient ii.e.
e
Sell forward $ 5,700

Rajiv Srivastava Economic Exposure 16

PAY OFF -Forward Contract
Assumed forward rate = Rs. 46/$
P fit/L
Profit/Loss on th
the fforward
d contract
t t
Exchange Rate Profit/Loss -
45 5,700 x 1 = 5,700
46 5,700 x 0 = 0
47 5 700 x -1
5,700 1 = - 5,700
5 700

Rajiv Srivastava Economic Exposure 17

RISK REDUCTION
Variance
V i off cash
h flflow with
ith and
d without
ith t th
the
forward contract
Ex Rate R CFforward Total
45 45,000 5,700 50,700
46 50,600 0 50,600
47 56 400
56,400 -5 700
-5,700 50 700
50,700
Variance of CF 216,62,222 2,222
Variance
V i off th
the cashh flflow reduces
d
drastically. The remaining variance (2222)
can nott be
b di diversified
ifi d away or eliminated.
li i t d
Rajiv Srivastava Economic Exposure 18
OPERATING Vs ECONOMIC EXPOSURE

Value of the firm may be used as proxy for

cash
h flflow
CF t x ER t
Value of the firm = (1 + WACC) t

Rajiv Srivastava Economic Exposure 19