Download MEASURING AND MANAGING CASH FLOW EXPOSURE

ECONOMIC EXPOSURE
Presenter: Van Phan
Agenda
FOREIGN EXCHANGE RISK AND
ECONOMIC EXPOSURE
II. THE ECONOMIC CONSEQUENCES
OF EXCHANGE RATE CHANGES
III. IDENTIFYING ECONOMIC
EXPOSURE
I.
Presenter: Van Phan
CONCEPT OF FOREIGN
EXCHANGE EXPOSURE
Economic exposure focuses on the impact of
currency fluctuations on the firm’s value.
1. Expectations about fluctuations must be
incorporated in all basic decisions of the
firm.
2. Definitions:
a. Accounting exposure: impact on firm’s
balance sheet
b. Economic exposure
i. Cash Flow exposure
ii. Net worth exposure
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Definition
Economic Exposure: The risk that
exchange rate changes may affect the
present value of future income streams.
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Case 1: No Deviation From PPP
An example of a U.S corporation’s British
Subsidiary
Assumption: PPP holds
– Nominal ER=  - * = S
– Domestic inflation less foreign inflation should
equal the change in the spot rate.
– Implies that the higher inflation country should
see its currency depreciate.= depreciation
of £ is the result of higher inflation in UK than
in U.S
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No Deviation From PPP
£ price of the product will rise in
accordance with British inflation
Results
– $price
– $ AC
– $ margin
– Volume
– Profit
No change
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Case 2: Real ER changes and selfcontained subsidiary-Price-Taker
Perfectly competitive market
British operation services the local market
and undertakes all production locally
£ depreciates in real term
– £ Price: not change: price taker
– $ Price: change
– $ Costs: change
– $ Profit margin: Decline in proportion of ER
change
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Real ER changes and selfcontained subsidiary-PriceTaker
$
MC
AC
MR
Po
MR’
P1
Co
C1
Q0
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Quantity
Real ER changes and selfcontained subsidiary-Price-Maker
The result is the same: Why
– £ denominated demand curve: no change
with the depreciation of £
– $ equivalent demand curse shift down
£ Price: not change: no change in D
$ Price: change
$ Costs: change
$ Profit margin: Decline in proportion of ER change
Presenter: Van Phan
Case 3: Real ER and a World
Output Market
Assumption:
– British subsidiary functions in a world market
for output
– The world price is determined in $ (MR=MR’)
Results of £ depreciation
– Change the cost structure because of the
local inputs
– Increase the production
= Increase profit
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Real ER and a World Output
Market
MC’
MC
$
AC
AC’
MR=MR’
Po
Co
C1
Q0
Q1
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Quantity
Case 4: Real ER and a World Input
Market
Assumption:
– Output is priced in £
– Input is priced in $ (MR=MR’)
Results of £ depreciation
– Shift the $MR down
– Cost function does not shift down
= cut production to reduce costs= profit
declines
Presenter: Van Phan
Case 5: Real ER and a World Input
& Output Market
Assumption
– Competing in a world of output
– Producing the output with factors supplied in a
world input market
Results of £ depreciation
– No shift the $MR
– No shift the cost function= no economic
exposure
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Conclusion
Local Currency Depreciation
Cases
PPP holds
U.S Dollar
Price
U.S. Dollar
AC
U.S Dollar
Margin
Volume
U.S Dollar
Profit
No Change
No Change
No Change
No Change
No Change
Real
Depreciation
and selfcontained
Decrease
Decrease
Decrease
No Change
Decrease
Real
Depreciation,
world output
Price Taker:
No change
Price Maker:
Decrease
Increase
Increase
Increase
Real
Depreciation,
world input
Decrease
No change
Decrease
Decrease
Decrease
Real
Depreciation,
world output &
input
No change
No change
No change
No change
No change
Presenter: Van Phan