This document contains a tutorial problem set on international financial management. It discusses economic exposure, which is the sensitivity of a firm's value and cash flows to unexpected changes in exchange rates. Even domestic firms can face economic exposure if their products compete with imports. The document provides examples of how to measure a firm's exposure to exchange rate risk by looking at how its foreign asset values and cash flows covary with exchange rates. Hedging techniques can be used to reduce this exposure.
This document contains a tutorial problem set on international financial management. It discusses economic exposure, which is the sensitivity of a firm's value and cash flows to unexpected changes in exchange rates. Even domestic firms can face economic exposure if their products compete with imports. The document provides examples of how to measure a firm's exposure to exchange rate risk by looking at how its foreign asset values and cash flows covary with exchange rates. Hedging techniques can be used to reduce this exposure.
This document contains a tutorial problem set on international financial management. It discusses economic exposure, which is the sensitivity of a firm's value and cash flows to unexpected changes in exchange rates. Even domestic firms can face economic exposure if their products compete with imports. The document provides examples of how to measure a firm's exposure to exchange rate risk by looking at how its foreign asset values and cash flows covary with exchange rates. Hedging techniques can be used to reduce this exposure.
This document contains a tutorial problem set on international financial management. It discusses economic exposure, which is the sensitivity of a firm's value and cash flows to unexpected changes in exchange rates. Even domestic firms can face economic exposure if their products compete with imports. The document provides examples of how to measure a firm's exposure to exchange rate risk by looking at how its foreign asset values and cash flows covary with exchange rates. Hedging techniques can be used to reduce this exposure.
FACULTY OF BUSINESS AND ECONOMICS FINA0105/2383A International Financial Management FIRST SEMESTER, 2014-2015
Tutorial 3 Chapter 9 Management of Economic Exposure
(Continue with Tutorial Problem Set 2 Question 2, 4 & 5)
Question 1 (Asset Exposure) 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.
Question 2 (Asset Exposure) 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% probability and a recession with a 30% 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. FINA0105/2383 International Financial Management Tutorial Problem Set 3
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(c) How would you hedge this exposure? If you hedge, what is the variance of the pound value of the hedged position?
FINA0105/2383 International Financial Management Tutorial Problem Set 3
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Chapter 9 Management of Economic Exposure What is 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 firms products compete with imported goods, then their competitive position is affected by the strength or weakness of the local currency.
Example: Consider a U.S. bicycle manufacturer who sources, produces, and sells only in the U.S.
Since the firms 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.
Exchange Rate Risk and Economic Exposure
Exchange rate risk is applied to the firms competitive position.
Any anticipated changes in the exchange rates would already have been discounted and reflected in the firms 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.
FINA0105/2383 International Financial Management Tutorial Problem Set 3
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How to Economic Exposure?
Economic exposure is the sensitivity of the future home currency value of the firm s assets and liabilities and the firms operating cash flow to random changes in exchange rates.
There exist statistical measurements of sensitivity:
- Sensitivity of the future home currency values of the firms assets and liabilities to random changes in exchange rates.
- Sensitivity of the firms operating cash flows to random changes in exchange rates.
Example: 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.
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. FINA0105/2383 International Financial Management Tutorial Problem Set 3
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Two Sources of 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