• Outline • Three Types of Exposure • How to Measure Economic Exposure • Operating Exposure: Definition • An Illustration of Operating Exposure • Determinants of Operating Exposure • Managing Operating Exposure
• Economic Exposure • Exchange rate risk as applied to the firm’s competitive position. • Extent to which the value of the firm is affected by unanticipated changes in ERs • Transaction Exposure • Exchange rate risk as applied to the firm’s home currency cash flows. • Sensitivity of “realized” domestic currency values of the firm’s contractual CFs denominated in foreign currencies to unexpected ER changes • Translation Exposure • Exchange rate risk as applied to the firm’s consolidated financial statements. • Potential that the firm’s consolidated financial statements can be affected by changes in ERs. Three Types of Exposure
Economic Exposure • Changes in exchange rates can affect not only firms that are directly engaged in international trade but also purely domestic firms. • Consider a Canadian bicycle manufacturer who sources and sells only in Canada. • Since the firm’s product competes against imported bicycles it is subject to foreign exchange exposure .
Channels of Economic Exposure Operating exposure Firm Value Home currency value of assets and liabilities Future operating cash flows Exchange rate fluctuations Asset exposure
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.
How to Measure Economic Exposure • If a Canadian 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 + bS + 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 • Exposure is the regression coefficient b.
How to Measure Economic Exposure The exposure coefficient, b , is defined as follows: • 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. Cov( P,S ) Var( S ) b =
Example • Suppose a Canadian firm has an asset in Britain 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.
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