Multinational Financial Management Alan Shapiro 7th Edition J.Wiley & Sons Power Points by Joseph F Greco, Ph.D California State University, Fullerton CHAPTER 11 MEASURING AND MANAGING ECONOMIC EXPOSURE CHAPTER OVERVIEW I FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE II THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES III IDENTIFYING ECONOMIC EXPOSURE IV CALCULATING ECONOMIC EXPOSURE V AN OPERATIONAL MEASURE OF EXCHANGE RISK VI MANAGING OPERATING EXPOSURE 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 Expectations about the fluctuation must be incorporated in all basic decisions of the firm FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE Definitions: a Accounting exposure impact on firm’s balance sheet b Economic exposure 1.) Transaction 2.) Operating FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE THE REAL EXCHANGE RATE et' et (1  i f ) t (1  ih ) t FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE B Real Exchange Rates and Risk Nominal v real exchange rates: the real rate has been adjusted for price changes FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE SUMMARY a the economic impact of a currency change depends on the offset by the difference in inflation rates or the real exchange rate b It is the relative price changes that ultimately determine a firm’s long-run exposure PART II THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES II ECONOMIC CONSEQUENCES A Transaction exposure On-balance sheet Off-balance sheet THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES II ECONOMIC CONSEQUENCES (con’t) B Operating Exposure : real rate change Pricing flexibility is key Product differentiation Substitution of inputs 10 AN OPERATIONAL MEASURE OF EXCHANGE RISK VI SUMMARY: A The focus of the accounting profession on the balance sheet impact of currency changes has led to ignoring the important impact on future cash flows 22 AN OPERATIONAL MEASURE OF EXCHANGE RISK B For firms incurring costs and selling products in foreign countries, the net effect of currency changes may be less important in the long run 23 AN OPERATIONAL MEASURE OF EXCHANGE RISK C To measure exposure properly, you must focus on inflation-adjusted or real exchange rates instead of nominal or actual exchange rates 24 AN OPERATIONAL MEASURE OF EXCHANGE RISK D It is difficult in practice to determine what the actual economic impact of a currency change will be 25 PART VI MANAGING OPERATING EXPOSURE I INTRODUCTION Operating exposure management requires long-term operating adjustments A Real v Nominal Changes Relative price changes leads to marketing and/or production revisions 26 MANAGING OPERATING EXPOSURE B Proactive Marketing and Production Initiatives Marketing: market selection product strategy pricing strategy promotional strategy 27 MANAGING OPERATING EXPOSURE B Proactive Marketing and Production Initiatives (con’t) Production: product sourcing input mix plant location raising productivity 28 MANAGING OPERATING EXPOSURE II Marketing Management Adjustments A Market Selection use advantage to carve out market share Market segmentation 29 MANAGING OPERATING EXPOSURE B Pricing strategy: Expectations critical If HC value falls, exporter gains competitive advantage by increasing unit profitability and market share The higher price elasticity of demand, the more currency risk the firm faces by product substitution 30 MANAGING OPERATING EXPOSURE C Following HC depreciation, local firm may have much more freedom in its pricing Promotional Strategy 31 MANAGING OPERATING EXPOSURE D Product Strategy exchange rate changes may alter The timing of new product introductions, Product deletion , Product innovation 32 MANAGING OPERATING EXPOSURE III Product Management Adjustments product sourcing and plant location are the A B C D principal variables to manipulate Input mix Shift production among plants Plant location Raising productivity 33 MANAGING OPERATING EXPOSURE IV Planning For Exchange-Rate Changes A With better planning and more competitive options, firms can change strategies substantially B before the impact of an currency change makes itself felt C Implication: compaction of adjustment period following an exchange-rate change 34 MANAGING OPERATING EXPOSURE V.Financial Management of Exchange Rate Risk: Financial manager’s Role in Marketing and Production A Provide local manager with forecasts of inflation and exchangerate changes B Identify and focus on competitive exposure 35 MANAGING OPERATING EXPOSURE C Design the evaluation criteria so that operating managers neither rewarded or penalized for unexpected exchange-rate changes D Estimate and hedge the operating exposure after adjustments made 36 ... currency change will be 25 PART VI MANAGING OPERATING EXPOSURE I INTRODUCTION Operating exposure management requires long-term operating adjustments A Real v Nominal Changes Relative price changes... sourcing input mix plant location raising productivity 28 MANAGING OPERATING EXPOSURE II Marketing Management Adjustments A Market Selection use advantage to carve out market share Market segmentation