CHAPTER 9 MANAGEMENT OF ECONOMIC EXPOSURE ANSWERS & SOLUTIONS TO END OF CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. How would you define economic exposure to exchange risk? Answer: Economic exposure can be defined as the possibility that the firm’s cash flows and thus its market value may be affected by the unexpected exchange rate changes. 2. Explain the following statement: “Exposure is the regression coefficient.” Answer: Exposure to currency risk can be appropriately measured by the sensitivity of the firm’s future cash flows and the market value to random changes in exchange rates. Statistically, this sensitivity can be estimated by the regression coefficient. Thus, exposure can be said to be the regression coefficient. 3. Suppose that your company has an equity position in a French firm. Discuss the condition under which the dollar/euro exchange rate uncertainty does not constitute exchange exposure for your company. Answer: Mere changes in exchange rates do not necessarily constitute currency exposure. If the euro value of the equity moves in the opposite direction as much as the dollar value of the euro changes, then the dollar value of the equity position will be insensitive to exchange rate movements. As a result, your company will not be exposed to currency risk. 4. Explain the competitive and conversion effects of exchange rate changes on the firm’s operating cash flow. Answer: The competitive effect: exchange rate changes may affect operating cash flows by altering the firm’s competitive position. The conversion effect: A given operating cash flows in terms of a foreign currency will be converted into higher or lower dollar (home currency)amounts as the exchange rate changes. 5. Discuss the determinants of operating exposure. Answer: The main determinants of a firm’s operating exposure are (i) the structure of the markets in which the firm sources its inputs, such as labor and materials, and sells its products, and (ii) the firm’s ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing. 6. Discuss the implications of purchasing power parity for operating exposure. Answer: If the exchange rate changes are matched by the inflation rate differential between countries, firms’ competitive positions will not be altered by exchange rate changes. Firms are not subject to operating exposure. 7. General Motors exports cars to Spain but the strong dollar against the euro hurts sales of GM cars in Spain. In the Spanish market, GM faces competition from the Italian and French car makers, such as Fiat and Renault, whose operating currencies are the euro. What kind of measures would you recommend so that GM can maintain its market share in Spain. Answer: Possible measures that GM can take include: (1) diversify the market; try to market the cars not just in Spain and other European countries but also in, say, Asia; (2) locate production facilities in Spain and source inputs locally; (3) locate production facilities, say, in Morocco where production costs are low and export to Spain from Morocco. 8. What are the advantages and disadvantages of financial hedging of the firm’s operating exposure vis-à-vis operational hedges (such as relocating manufacturing site)? Answer: Financial hedging can be implemented quickly with relatively low costs, but it is difficult to hedge against long-term, real exposure with financial contracts. On the other hand, operational hedges are costly, time-consuming, and not easily reversible. 9. Discuss the advantages and disadvantages of maintaining multiple manufacturing sites as a hedge against exchange rate exposure. Answer: To establish multiple manufacturing sites can be effective in managing exchange risk exposure, but it can be costly because the firm may not be able to take advantage of the economy of scale. 10. Evaluate the following statement: “A firm can reduce its currency exposure by diversifying across different business lines.” Answer: Conglomerate expansion may be too costly as a means of hedging exchange risk exposure. Investment in a different line of business must be made based on its own merit. 11. The exchange rate uncertainty may not necessarily mean that firms face exchange risk exposure. Explain why this may be the case. Answer: A firm can have a natural hedging position due to, for example, diversified markets, flexible sourcing capabilities, etc. In addition, to the extent that the PPP holds, nominal exchange rate changes do not influence firms’ competitive positions. Under these circumstances, firms do not need to worry about exchange risk exposure. PROBLEMS 1. Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pound will be worth $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability. (a) Estimate your exposure b to the exchange risk. (b) Compute the variance of the dollar value of your property that is attributable to the exchange rate uncertainty. (c) Discuss how you can hedge your exchange risk exposure and also examine the consequences of hedging. Solution: (a) Let us compute the necessary parameter values: E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580 E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44 Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2 = .00096+.00144 = .0024. Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44) = -5.28-7.92 = -13.20 b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500. You have a negative exposure! As the pound gets stronger (weaker) against the dollar, the dollar value of your British holding goes down (up). (b) b2Var(S) = (-5500)2(.0024) =72,600($)2 (c) Buy £5,500 forward. By doing so, you can eliminate the volatility of the dollar value of your British asset that is due to the exchange rate volatility. 2. A U.S. firm holds an asset in France and faces the following scenario: State 1 State 2 State 3 State 4 Probability 25% 25% 25% 25% Spot rate $1.20/€ $1.10/€ $1.00/€ $0.90/€ P* €1500 €1400 €1300 €1200 P $1,800 $1,540 $1,300 $1,080 In the above table, P* is the euro price of the asset held by the U.S. firm and P is the dollar price of the asset. (a) Compute the exchange exposure faced by the U.S. firm. (b) What is the variance of the dollar price of this asset if the U.S. firm remains unhedged against this exposure? (c) If the U.S. firm hedges against this exposure using the forward contract, what is the variance of the dollar value of the hedged position? Solution: (a) E(S) = .25(1.20 +1.10+1.00+0.90) = $1.05/€ E(P) = .25(1,800+1,540+1,300 +1,080) = $1,430 Var(S) = .25[(1.20-1.05)2 +(1.10-1.05)2+(1.00-1.05)2+(0.90-1.05)2] = .0125 Cov(P,S) = .25[(1,800-1,430)(1.20-1.05) + (1,540-1,430)(1.10-1.05) (1,300-1,430)(1.00-1.05) + (1,080-1,430)(0.90-1.05)] = 30 b = Cov(P,S)/Var(S) = 30/0.0125 = €2,400. (b) Var(P) = .25[(1,800-1,430)2+(1,540-1,430)2+(1,300-1,430)2+(1,080-1,430)2] = 72,100($)2. (c) Var(P) - b2Var(S) = 72,100 - (2,400)2(0.0125) = 100($)2. This means that most of the volatility of the dollar value of the French asset can be removed by hedging exchange risk. The hedging can be achieved by selling €2,400 forward. 3. Suppose you are a British venture capitalist holding a major stake in an e-commerce start-up in Silicon Valley. As a British resident, you are concerned with the pound value of your U.S. equity position. Assume that if the American economy booms in the future, your equity stake will be worth $1,000,000, and the exchange rate will be $1.40/£. If the American economy experiences a recession, on the other hand, your American equity stake will be worth $500,000, and the exchange rate will be $1.60/£. You assess that the American economy will experience a boom with a 70 percent probability and a recession with a 30 percent probability. (a) Estimate your exposure to the exchange risk. (b) Compute the variance of the pound value of your American equity position that is attributable to the exchange rate uncertainty. (c) How would you hedge this exposure? If you hedge, what is the variance of the pound value of the hedged position? Solution: Prob = 0.70 P* = $1,000,000 S = $1.40 P = £714,300 Prob = 0.30 P* = $500,000 S = $1.60 P = £312,500 E(S) = (0.70)/(1.40) + (0.30)/(1.60) = £0.688/$ E(P) = (0.70)*(714,300) + (0.30)*(312,500) = £593,760/$ Var(S) = 0.00167 Cov(P,S) = 7,535 (a) b = Cov(P,S)/Var(S) = 7,535/0.00167 = 4,511,976 ($) (b) b2Var(S) = (4,511,976)2*(0.00167) = 33,997,738,800 (c) Var(e) = Var(P) - b2Var(S) = 33,903,080,400 - 33,997,738,800 ≈ 0 You can hedge this exposure by selling $4,511,976 forward. MINI CASE: ECONOMIC EXPOSURE OF ALBION COMPUTERS PLC Consider Case 3 of Albion Computers PLC discussed in the chapter. Now, assume that the pound is expected to depreciate to $1.50 from the current level of $1.60 per pound. This implies that the pound cost of the imported part, i.e., Intel’s microprocessors, is £341 (=$512/$1.50). Other variables, such as the unit sales volume and the U.K. inflation rate, remain the same as in Case 3. (a) Compute the projected annual cash flow in dollars. (b) Compute the projected operating gains/losses over the four-year horizon as the discounted present value of change in cash flows, which is due to the pound depreciation, from the benchmark case presented in Exhibit 12.4. (c) What actions, if any, can Albion take to mitigate the projected operating losses due to the pound depreciation? Suggested Solution to Economic Exposure of Albion Computers PLC a) The projected annual cash flow can be computed as follows: ______________________________________________________ Sales (40,000 units at £1,080/unit) £43,200,000 Variable costs (40,000 units at £697/unit)£27,880,000 Fixed overhead costs 4,000,000 Depreciation allowances 1,000,000 Net profit before tax £15,315,000 Income tax (50%) 7,657,500 Profit after tax 7,657,500 Add back depreciation 1,000,000 Operating cash flow in pounds £8,657,500 Operating cash flow in dollars $12,986,250 ______________________________________________________ b) ______________________________________________________ Benchmark Current Variables Case Case ______________________________________________________ Exchange rate ($/£) 1.60 1.50 Unit variable cost (£) 650 697 Unit sales price (£) 1,000 1,080 Sales volume (units) 50,000 40,000 Annual cash flow (£) 7,250,000 8,657,500 Annual cash flow ($) 11,600,000 12,986,250 Four-year present value ($) 33,118,000 37,076,946 Operating gains/losses ($) 3,958,946 ______________________________________________________ c) In this case, Albion actually can expect to realize exchange gains, rather than losses. This is mainly due to the fact that while the selling price appreciates by 8% in the U.K. market, the variable cost of imported input increased by about 6.25%. Albion may choose not to do anything about the exposure. Management of Economic Exposure Chapter Nine Chapter Outline • How to Measure Economic Exposure • Operating Exposure: Definition • An Illustration of Operating Exposure • Determinants of Operating Exposure • Managing Operating Exposure Economic Exposure • Changes in exchange rates can affect not only firms that are directly engaged in international trade but also purely domestic firms. • If the domestic firm’s products compete with imported goods, then their competitive position is affected by the strength or weakness of the local currency. Economic Exposure • Consider a U.S. bicycle manufacturer who sources, produces, and sells only in the U.S. • Since the firm’s product competes against imported bicycles, it is subject to foreign exchange exposure. • Their customers are comparing the cost and features of the domestic bicycle against Japanese, British, and Italian bicycles. Economic Exposure • Exchange rate risk is applied to the firm’s competitive position. • Any anticipated changes in the exchange rates would already have been discounted and reflected in the firm’s value. • Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Exchange Rate Exposure of U.S. Equity Portfolios 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. – Sensitivity of the future home currency values of the firm’s assets and liabilities to random changes in exchange rates. – Sensitivity of the firm’s operating cash flows to random changes in exchange rates. Channels of Economic Exposure 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: P = a + b×S + e Where a is the regression constant. 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. How to Measure Economic Exposure The exposure coefficient, b, is defined as follows: Cov(P,S) b = Var(S) 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. How to Measure Economic Exposure • The exposure coefficient shows that there are two sources of economic exposure: 1. The variance of the exchange rate. 2. The covariance between the dollar value of the asset and exchange rate. Cov(P,S) b = Var(S) Example • Suppose a U.S. firm has an asset in France whose local currency price is random. • For simplicity, suppose there are only three states of the world and each state is equally likely to occur. • The future local currency price of this French asset (P*) as well as the future exchange rate (S) will be determined, depending on the realized state of the world. Example (continued) State Probability P* S S×P* Case 1 1 1/3 €980 $1.40/€ $1,372 2 1/3 €1,000 $1.50/€ $1,500 3 1/3 €1,070 $1.60/€ $1,712 Case 2 1 1/3 €1,000 $1.40/€ $1,400 2 1/3 €933 $1.50/€ $1,400 3 1/3 €875 $1.60/€ $1,400 Case 3 1 1/3 €1,000 $1.40/€ $1,400 2 1/3 €1,000 $1.50/€ $1,500 3 1/3 €1,000 $1.60/€ $1,600 Example (continued) State Probability P* S S×P* Case 1 1 1/3 €980 $1.40/€ $1,372 2 1/3 €1,000 $1.50/€ $1,500 3 1/3 €1,070 $1.60/€ $1,712 • In case one, the local currency price of the asset and the exchange rate are positively correlated. – This gives rise to substantial exchange rate risk. Example (continued) State Probability P* S S×P* Case 2 1 1/3 €1,000 $1.40/€ $1,400 2 1/3 €933 $1.50/€ $1,400 3 1/3 €875 $1.60/€ $1,400 • In case two, the local currency price of the asset and the exchange rate are negatively correlated. – This ameliorates the exchange rate risk substantially (completely in this example). Example (continued) State Probability P* S S×P* Case 3 1 1/3 €1,000 $1.40/€ $1,400 2 1/3 €1,000 $1.50/€ $1,500 3 1/3 €1,000 $1.60/€ $1,600 • In case three, the local currency price of the asset is fixed at €1,000. – This “contractual” exposure can be completely hedged using the methods we learned in Chapter 8. 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. An Illustration of Operating Exposure • There was an enormous shortage in the shipping market from Asia due to the Asian currency crisis. • This affected not only the shipping companies, who enjoyed “boom times,” but also retailers, who experienced increased costs and delays. 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. 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 market structure of inputs and products; how competitive or how monopolistic the markets facing the firm are. – The firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes. Managing Operating Exposure • Selecting Low Cost Production Sites • Flexible Sourcing Policy • Diversification of the Market • R&D and Product Differentiation • Financial Hedging Selecting Low Cost Production Sites • A firm may wish to diversify the location of its production sites to mitigate the effect of exchange rate movements. • For example, 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 and increased exchange rate volatility. Flexible Sourcing Policy • Sourcing does not apply only to components, but also to “guest workers.” • For example, 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. Diversification of the Market • Selling in multiple markets to take advantage of economies of scale and diversification of exchange rate risk. R&D and Product Differentiation • Successful research and development (R&D) 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. 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 the use of derivative securities such as currency swaps, futures, forwards, and currency options, among others. Financial Hedging Example: Case 1 • Financial hedging requires a knowledge of the extent to which the firm’s operating cash flows are affected by the exchange rate. • In the earlier example, consider Case 1. • Here the foreign currency earnings are positively correlated with the exchange rate changes. State Probability P* S S×P* Case 1 1 1/3 €980 $1.40/€ $1,372 2 1/3 €1,000 $1.50/€ $1,500 3 1/3 €1,070 $1.60/€ $1,712 Case 1: Computation of Beta 1. Computation of Means P = 1/3 × (€1,372 + €1,500 + €1,712) = €1,528 S = 1/3 × ($1.40/€ + $1.50/€ + $1.60/€) = $1.50/€ 2. Computation of Variance and CovarianceVar(S) = 1/3 × [($1.40/€ – $1.50/€)2 + ($1.50/€ – $1.50/€)2 + ($1.60/€ – $1.50/€)2] = 0.02/3 Cov(Pi S) = 1/3 ×[(€1,372 – €1,528)($1.40/€ – $1.50/€) + (€1,500 – €1,528)($1.50/€ – $1.50/€) + (€1,712 – €1,528)($1.60/€ – $1.50/€)] = 34/3 3. Computation of the Exposure Coefficient = Cov(P,S)/Var(S) = (34/3)/(0.02/3) = €1,700 State Probability P* S S×P* 1 1/3 €980 $1.40/€ $1,372 2 1/3 €1,000 $1.50/€ $1,500 3 1/3 €1,070 $1.60/€ $1,712 Financial Hedging Example: Case 1 At T = 0, if we sell €1,700 forward at the 1-year forward rate, F1($/€), that prevails at time zero. Suppose that F1($/€) = $1.48. T = 0 T = 1 P* €980 S1($/€) × $1.40/€1 = $1,372 F1($/€) Sell €1,700×$1.50/€1=$2,550 Buy €720 at $1.40/€1 =$1,008 net cash flow =$1,542 €1,000 × $1.50/€1 = $1,500 Sell €1,700×$1.50/€1=$2,550 Buy €700 at $1.50/€1 =$1,050 net cash flow =$1,500 €1,070 × $1.60/€1 = $1,712 Sell €1,700×$1.50/€1=$2,550 Buy €630 at $1.60/€1 =$1,008 net cash flow =$1,542 Financial Hedging Example: Case 2 • In Case 2, we have a built-in hedge, requiring no derivatives. • You can also calculate as zero using the same previous methodology. State Probability P* S S×P* Case 2 1 1/3 €1,000 $1.40/€ $1,400 2 1/3 €933 $1.50/€ $1,400 3 1/3 €875 $1.60/€ $1,400 Financial Hedging Example: Case 2 At T = 0, if we sell b = €0 forward at the 1-year forward rate that prevails at time zero (suppose that F1($/€) = $1.50). T = 0 T = 1 P* S1($/€) × $1.40/€1 = $1,400 × $1.50/€1 = $1,400 × $1.60/€1 = $1,400 Financial Hedging Example: Case 3 • Financial hedging requires a knowledge of the extent to which the firm’s operating cash flows are affected by the exchange rate. • In an earlier example from Chapter 8, we showed how to hedge case three: simply sell = €1,000 forward or use a money market hedge. State Probability P* S S×P* Case 3 1 1/3 €1,000 $1.40/€ $1,400 2 1/3 €1,000 $1.50/€ $1,500 3 1/3 €1,000 $1.60/€ $1,600 Financial Hedging Example: Case 3 At T = 0, sell €1,000 forward at the 1-year forward rate F1($/€) that prevails at time zero. Suppose that F1($/€) = $1.50. T = 0 T = 1 P* S1($/€) €1,000 × $1.40/€1 = $1,400 P* F1($/€) €1,000 × $1.50/€1 = $1,500 €1,000 × $1.50/€1 = $1,500 €1,000 × $1.50/€1 = $1,500 €1,000 × $1.60/€1 = $1,600 €1,000 × $1.50/€1 = $1,500 Solution Manual for International Financial Management Cheol S. Eun, Bruce G. Resnick 9780077861605
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