Exchange Rate Exposure of a Global Competitor _ 1990

The Exchange Rate Exposure of a Global Competitor
Author(s): Timothy A. Luehrman

Source: Journal of International Business Studies, Vol. 21, No. 2 (2nd Qtr., 1990), pp. 225-
242
Published by: Palgrave Macmillan Journals
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THE EXCHANGE RATE EXPOSURE
OF A GLOBAL COMPETITOR
Timothy A. Luehrman*
Harvard University
Abstract. This paper analyzes the exposure of operating cash

flows to an exogenous exchange rate change for a firm operating
internationally as a multimarket oligopolist (i.e., a "global"
competitor) and facing demand that depends in a general way
on the exchange rate. It is shown that exposure is the sum of
a base case exposure identified in other studies and two other
components: terms associated with exchange rate-induced demand
shifts and terms associated with competitors' reoptimization
following the exchange rate shock. In generl, the magnitudes of
these additional terms are significant, especially in the presence
of asymmetries across markets and firms. Numerical examples
are provided that incorporate asymmetries corresponding to
stylized facts about some U.S. markets and U.S. manufacturers.
The international economic environment is presently characterized by vola-

tile exchange rates and apparent deviations from Purchasing Power Parity
that are both frequent and persistent. Changes in real exchange rates have
been dramatic by almost any standard. At the same time, more and more
product markets are characterized by international competition. In many
cases, a form of "global" competition takes place among a small number
of firms, and one or more national product markets assumes an obvious
strategic importance. As a result, the effect of changing real exchange rates
on global competitors has received considerable attention from economists,
managers and policymakers.
Most formal analyses of such exchange rate exposures corroborate what has
emerged as the orthodox view: a domestic currency depreciation increases
the operating cash flows of a domestic firm engaged in exporting and/or
competing with imports. This is because a cheaper domestic currency, to
a greater or lesser extent depending on demand and supply elasticities,
allows a domestic firm to charge a higher price for its exports while under-
cutting import prices. Unfortunately, many of the models that produce this
*Timothy A. Luehrman is Assistant Professor of Business Administration and a

member of the finance area at the Harvard Business School. He holds Ph.D. and
M.B.A. degrees from Harvard University.
I am grateful to Richard E. Caves, W. Carl Kester, Donald R. Lessard, David W. Mullins, Jr., Anant
K. Sundaram, and three anonymous referees. Support for this research was provided by the Division
of Research, Graduate School of Business Administration, Harvard University.
Received: June 1988; Revised: March & May 1989; Accepted: July 1989.
225
226 JOURNAL OF INTERNATIONAL BUSINESS STUDIES, SECOND QUARTER 1990
result do not embody the features of the world economy that made the
problem interesting and important in the first place. These are: (1) a macro-
economy in which both the firm and its customers and suppliers are
exposed to exchange rate shocks; and (2) the emergence of global compe-
tition among large multinational firms within product markets of varying
size and strategic importance. This paper highlights the importance of these
considerations by incorporating them into a simple model of bimarket
duopolists facing demand that depends in a general way on the exchange
rate.
The paper shows that such a duopolist's exposure is not well described
by earlier models. This exposure is the sum of a base case ("orthodox")
exposure, identified in previous studies, and two other components: terms
associated with exchange rate-induced demand shifts and terms associated
with firms' reoptimization following an exchange rate shock. The former
arise from the direct dependence of demand on relative currency values
and are included in exposures identified by Flood and Lessard [1986] and
Choi [1986]. The latter are due to imperfect competition within and across
national product markets. These additional components of exposure can
easily have significant magnitudes and thus overwhelm the base case expo-
sure. Depending on their signs, they can offset the base case, yielding an
"unorthodox" exposure, or "double it up," giving a much larger exposure
than existing models would suggest.
Finally, the paper uses numerical examples to show that for firms based in
"strategic" national product markets, the components of exposure associ-
ated with demand shifts and reoptimization may be especially prominent.
This is precisely the position occupied by U.S. firms in many industries
(e.g., automobiles, pharmaceuticals, semiconductors). That such firms are
likely to have exposures with significantly different magnitudes and
possibly different signs from those commonly anticipated should be of
some practical importance to the firms and to public sector decisionmakers
such as trade negotiators, legislators and central bankers.
The paper is organized as follows: the second section reviews some
previous work on operating exposure to exchange rates. In section three,
operating exposure is formally defined and a model of the multimarket
oligopolist's exposure is presented. The fourth section presents numerical
examples embodying some stylized facts about U.S. firms and markets.
The final section presents conclusions.
PREVIOUS STUDIES
The value of expected future operating cash flows depends on r

and will change when relative prices change. If the change in relative
prices is brought about by an exchange rate shock, the associated change
in the value of operating cash flows is referred to as ''operating exposure"
to the particular exchange rate(s).1 Theoretical treatments of operating expo-
sure have appeared in both the managerial and financial economics literature
since the breakdown of the Bretton Woods system in the early 1970s.
EXCHANGE RATE EXPOSURE 227
Many executives immediatel

affect firms' operations, as evidenced by Dufey [1972] and Ankrom [1974].
Managerial literature on the subject has proliferated since then as the world
economy changed and as the phenomenon became better understood. Good
recent examples are Levi [1983], Flood and Lessard [1986], and Lessard
and Lightstone [1986]. They emphasize the importance of real rather than
nominal exchange rates, the nature of the firm's activities, the approximate
currency domain of prices, and the operating options available to the firm
and its competitors. In general, such studies have been more comprehen-
sive, but necessarily less rigorous than those appearing in the financial
economics literature.
Shapiro [1975] formally analyzes the profit function of a multinational
corporation's foreign subsidiary in a two-country setting. Imperfect compe-
tition is not explicitly treated, though Shapiro notes that competition will
affect the partial derivatives of price with respect to the inflation and
devaluation rates. These partials "depend on whether foreign producers are
content to keep their market shares relatively constant by allowing their
prices to rise or whether they will use their new cost advantage to hold
prices down, thereby increasing their market shares."2 The model does not
solve the foreign producers' optimization problem to determine whether
higher market share or higher prices will maximize value. This indirect
treatment of competition makes the firm's problem analogous to that of a
monopolist rather than an oligopolist. Shapiro accordingly obtains the
usual result; export-oriented firms and those facing import competition will
usually benefit from a depreciation of their home currency.
Hekman's [1985] model examines the exposure of cash flows to equity
holders, of which operating exposure is a component, i.e., operating expo-
sure represents the exposure of firm value, from which the (contractual)
exposure of debt is subtracted to arrive at the exposure of equity. Hekman
shows that the elasticity of firm value with respect to the exchange rate is
simply one minus the elasticity of foreign currency operating revenues with
respect to the exchange rate. However, the firm examined is implicitly a
perfect competitor and its exposure is "orthodox" in the sense described
above. Similarly, Choi [1986] explicitly treats exposure in terms of input
and output demand elasticities that include what this paper identifies as
"demand shift" components of exposure. Thus the exposure of a firm
operating in more than one market has an ambiguous sign, regardless of
strategic effects arising from imperfect competition.3
Flood [1985] examines operating exposures arising in three different com-
petitive settings: perfect competition, monopolistic competition, and price
discrimination, with the last of these being a world of monopolistic compe-
tition in which the law of one price is not assumed to hold. Flood's main
purpose is to investigate what happens to exposures as firms implement
strategies (e.g., lower marginal costs, or increased product differentiation)
intended to cope with "increased global competition," i.e., with market
imperatives that are not necessarily related to the exchange rate shocks
examined.4 The exposures themselves, both before and after strategy
changes, are formally analogous to those of a perfect competitor and, in
the case of monopolistic competition, a pure monopolist.
All of these models are consistent with the view that export-oriented and
import-competing firms benefit from a real depreciation of the home
currency. However, none examines the behavior of large firms operating
internationally as oligopolists. Thus, while it is generally agreed that the
competitive structure of the industry is a critical determinant of exposure,
very few types of competition have received formal attention.
An exception is Sundaram and Mishra [1988a], who developed indepen-
dently a modelling strategy similar to the one adopted in this paper. They
analyze the phenomenon of currency pass-through in a multiperiod frame-
work. They are especially interested in pricing strategies in the presence of
learning by one or more competitors. This paper adopts a similar notion
of global competition, but focuses on spatial rather than sequential analysis
and on asymmetries across product markets, such as different sizes and
demand elasticities.
This paper's primary extension of previous work on operating exposure is
its explicit treatment of the competitive interactions between oligopolists. It
shows how a firm's exposure depends on its competitor's optimal response
to an exchange rate shock. Further, by introducing the exchange rate as an
argument in the demand function, the paper separates strategic elements of
exposure from those due to the direct effects of exchange rate changes on
consumers. Finally, it shows that both of these elements of exposure are
amplified by asymmetries in market characteristics such as size and
demand elasticity, and firm characteristics such as cost structures.
MODEL OF A GLOBAL COMPETITOR'S EXPOSURE
Definition of Operating Exposure
Operating exposure is defined as the derivative of firm value with respect

to the exchange rate. This definition of operating exposure accommodates
changes in risk and capitalization rates in addition to changes in expected
cash flows. However, this paper considers only the narrow problem of
changes in expected cash flows, and does so only in a partial equilibrium
model. For this purpose, the exchange rate is assumed to be exogenous and
the model analyzes an exogenous, permanent exchange rate shock. Such a
shock will not be accompanied by changes in discount rates. While this is
clearly an unrealistic assumption, it has the benefit of isolating effects on
expected operating cash flows. This facilitates both an analysis of firm-and
industry-level phenomena and a comparison with the results of previous
studies, and the associated literature on exchange rate pass-through. In
contrast, the relationship between exchange rates and capitalization rates
would be more usefully examined in the context of a macroeconomic
general equilibrium.
Global Competition
A global competitor is distinguished by its coordination of internationally

dispersed activities in pursuit of a business strategy that recognizes the inter-
dependence of competitive positions in different countries or regions. A
descriptive analysis of global competition and its implications for firms'
strategic choices is provided in Porter [1980].5 Although the term "global
competition" is more generic than specific, it conveys two important ideas:
first, that a firm's actions in one market affect its own and its competitors'
actions in another; and second, global competition involves imperfect
competition of one kind or another, with one or more firms possessing
market power in one or more markets.
The specific model employed here is a simple bimarket duopoly, that is,
a generalized version of the model presented by Bulow, Geanakoplos and
Klemperer (BGK) [1985].8 In this model, an exogenous exchange rate shock
has both direct and indirect effects on firm value. The indirect effects
result from reoptimizations following the shock and feed back into each
firm's operating exposure. Though indirect, these effects have first-order
significance and constitute a large fraction of the duopolists' exposures.
Obviously, different games between the oligopolists will yield different equi-
libria and exposures. The BGK multimarket oligopoly is a useful general-
ization because it requires little in the way of complex machinery and
restrictive assumptions. Specific assumptions can be adopted for particular
cases.7
BGK show that the indirect effects depend on whether the firms' products
are strategic substitutes or strategic complements, i.e., whether they exhibit
economies or diseconomies of scope and whether more aggressive play by
one firm in one market raises or lowers the marginal profitability of the
other firm in that market. This paper shows that, in addition to these
considerations, an oligopolist's operating exposure depends on the degree
to which its competitor's marginal profits in each market are raised or
lowered by an exchange rate shock. This characteristic will be referred to
as the "strategic denomination" of the competitor's output. In the spirit of
BGK, it is "strategic" because it characterizes marginal rather than total
profits or revenues.8
The Model
There are two countries, domestic and foreign, and two firms, one based
in each country. The firms manufacture only in their home countries and
produce a homogeneous product, good x.9 Both firms may sell in either or
both countries and there is no inflation in either country. The firms select
quantities to be sold in each market during a single period. Let the
domestic firm be Firm 1 and the foreign, Firm 2.
Firms and consumers regard a shift in the exchange rate as a once-and-
for-all change. Since there is no inflation, the change is real and represents
a change in relative prices. Firms reoptimize accordingly. Prices in each

market are given by:
Pd = Pd(qId, q2d 5) (1)
Pfl=jPf(qIf q2f S) (2)

where
Pj = price of good x in market j, expressed in

j = d(omestic), f(oreign);
qij = quantity sold by firm i (i= 1, 2) in market j (j= d, f);
S = the exchange rate (domestic currency/foreign currency).
The model permits price discrimination between markets by not imposing
the law of one price on good x. As will be seen, this becomes an impor-
tant consideration in the context of the market asymmetries considered
below. The presence of the exchange rate as a separate argument in the
inverse demand functions permits a shift in the exchange rate to affect
consumers directly. For example, an increase in S may be thought of as
increasing the wealth, measured in domestic currency, of domestic country
residents. Depending on consumers' utility functions, the increase in
wealth may increase demand for good x in the domestic country. For a
given quantity, consumers would be willing to offer a higher domestic
price so that 6Pd/6S>O. Obviously, firms are exposed to this effect on
consumers. This effect is not captured if the role of the exchange rate is
limited to translating foreign currency into domestic currency within a
demand function that displays no other dependence on S. In contrast, for
the functions above, there is no currency in which prices may be expressed
and appear "denominated" in that currency.
Cost functions for each firm are:
ci = Iqqd +qif)s i=1, 2 (3)
where cl and c2 are expressed in domestic and for

tively. Note that cost functions also could be gene
exchange rate as a separate argument, which would a
effects of the exchange rate on factor markets or f
Firms select quantities in each market to maximize p
as given by:
ir1 =Pdqld + SPf q1f-cl, (4)
W2 = (/S)Pdq2d +Pf q2f -c2, (5)
where wr and 'r2 are expressed in domestic and foreign curren

tively. An interior Nash equilibrium requires:
67r /Ild = 67r /&If = 672/&2d = b72/&I2f = 0 (6)
Firm l's exposure is obtaine

terms in the resulting expr
dir /dS= Pf q1f+ qd(6P
+ [qjd(6Pd/I2d)](dq
+ [Sqlf(6Pf/'q2f)](dq2f/dS). (7)
Similarly differentiating 'r2 with respect to S and simplif

exposure:
d7r2/dS = -(1 /S2)Pdq2d + (1 IS)q2d(6Pd/6S) + q2$bPf/6S)
+ [(l/S)q2d(/Pd1/d)](dq1d/6S)
+ [q2f(6Pf /&1f)](dq1f /dS). (8)

Equations (7) and (8) give the exposures of the two firms. Each equation
contains three types of terms: revenues from abroad; demand shift terms
for each market; and "strategic interaction" terms. The first of these,
revenues from abroad, is the familiar "base case" exposure identified in
previous studies. It appears in equation (7) as Pf qlf and in equation (8) as
-(l/S2)Pdqm,. Equilibrium values for the base case exposures are obtained
by solving equations (6) simultaneously for quantities. Evaluating the
inverse demand functions at equilibrium quantities (given S) yields prices
Pd and Pf.
Next, each firm's exposure contains two exchange rate demand shift terms,
one for each market. For Firm 1 (equation (7)) these are q1,(6Pd/6) and
Sq1$(6Pf/6S). For Firm 2 (equation (8)), multiplying by S, they are q2d6Pdl
6S) and Sq2f(6P/S). II For both firms, these terms will have the same
signs as the partials 6Pd/6S and bPf/6S, which correspond to the total elas-
ticities identified by Choi [1986]. The appearance of these terms is due to
the direct dependence of demand on the exchange rate, and not to the form
of competition among firms. Perfect competitors or a monopolist would be
similarly exposed to the direct effect of the exchange rate shock on their
customers. Moreover, a generalization of cost functions would result in
similar cost shift terms in the expression for operating exposure, reflecting
direct effects of an exchange rate shock on suppliers.
The remaining terms in the expressions for exposure may be called
"strategic interaction" terms. They are a direct consequence of the two
firms' market power. Each firm's action in one market can induce a change
in its competitor's strategy in either market by changing its own margina
revenues and costs from serving that market. For Firm 1 (equation (7)) the
strategic interaction terms are: [qjd(bPd/2d)](dq2d/dS) and [Sqlf(6P
J2f)](dq2/dS). The portion of each in square brackets is easily evaluate
in equilibrium. In each case, the whole term has a sign opposite that of
dq2d/dS and dqZf/dS, respectively, which represent Firm 2's quantity
response to the shock. In other words, this part of Firm l's exposure
depends on Firm 2's response in each market to the exchange rate shock.
Equation (8) contains the corresponding strategic interaction terms for
Firm 2, which depend on Firm l's response to the shock.
Whether the strategic interaction terms offset or reinforce the base case
exposures depends on how the firms respond in each market to the shock,
i.e., on the signs of the derivatives dqij/dS. This is the same as saying
that it matters whether a firm's competitor will optimally pursue higher
prices or higher market share. A formal representation of the determinants
of each firm's response to the shock follows from requirements for a
Cournot-Nash equilibrium.
Following BGK, profits may be expressed as functions of choice variables
(quantities) and a shock variable (the exchange rate). First-order conditions
are given by equations (6). Total differentiation of the first FOC gives:
(627 lbq jaId)dqId + (62ir1/&J1qIf)dq1f+ (6b2w/716dq2d)dq2d
+ (62 w/ .6qZf)dqZf+ (62r1 /&ljI5S)dS = 0. (9)

Differentiating all the FOCs and dividing by dS gives a system of sim
taneous equations in the quantity derivatives:
62 . dqld -627r1
5qjbqld 8qldbqf bqldbqR2d bqldbq;f dS _ qjS
162X2 627r2 627r2 627r2 dq_f -627r2
6s2 62X
8q2dVqld 62X
8q,5qjf 62w
8q2jqk2d 6X
8q 1q dS
aq@ld 6q2ahqjf
8q2,jlqd fq&b2dbq2d 6q2ahq2f
~8~~ qq dS 8~dSq2dS
(10)
Alternatively, in matrix notation:
A(dq1,/dS)=b, (11)
where A is the matrix of second par

to quantities, i.e., the partial deriv
right-hand side of equation (10), the
with respect to the exchange rate.
Premultiplying both sides of equation (11) by the inverse of the coefficient

matrix A gives solutions for dq IdS, the derivatives of quantities with
respect to the exchange rate. These solutions are substituted into the
strategic interaction terms and determine the signs of the latter.
The firms' responses to the exchange rate shock can now be seen to depend
on three characteristics of the product market: (1) whether there are
(dis)economies of scope across markets; (2) whether the firms' products
are strategic substitutes or complements; and (3) the change in each firm's
(own-quantity) marginal profit associated with the exchange rate shock, or
the "strategic denomination" output. The effect of each of these character-
istics on Firm l's response to the shock (and hence, on Firm 2's exposure)
can be seen directly by partitioning equation (10) and solving for Firm l's
reaction function:
dq1/dS=A11_1[b1 -A12(dq21/dS)], (12)
where All and A12 are the upper left and right submatrice
of the coefficient matrix A in equation (11); b, and dq1j/d
element subparts of their corresponding vectors in equation (11).
All contains elements that determine whether Firm 1 experiences
(dis)economies of scope across foreign and domestic markets. These are
%2ir/&Ijd6qV and 62rll/&V&ld; positive values indicate economies of
scope. The elements of A12 indicate whether Firm l's and Firm 2's
products are strategic substitutes or complements; i.e., whether Firm l's
marginal profit in a given market is increased or decreased by an increase
in Firm 2's output in the same market. These elements are the partials
b2,rj6qljjqA for j=d, f). The elements- of b, indicate whether Firms l's
marginal profits in a given market rise or fall with an increase in the
exchange rate. These are the partials 627r1/&qhjjS for j=d, f and they
correspond to the strategic denomination of Firm l's output.
"Strategic denomination" denotes the response of marginal rather than total
profits to an exchange rate shock. Firm l's marginal profit in a particular
market may be thought of as an amount of currency. Whether that amount
rises or falls with a change in the exchange rate reveals its "denomination."
If 62%i1/&jq6S is positive, Firm l's marginal profit in the foreign marke
rises as the domestic currency depreciates. This is the same sign as the
effect on cash balances denominated in the foreign currency. In this sense,
the marginal profit curve, 6%-j1/&q, may be said to be "denominated" in
the local (foreign) currency. In general, the strategic denomination of a
firm's output depends on 6Pj/6S. Thus, the direct dependence of demand
on the exchange rate affects operating exposures through both the strategic
interaction terms and the demand shift terms discussed above.
ASYMMETRIES AND NUMERICAL EXAMPLES
The preceding section showed that imperfect competition and the direct
dependence of demand on the exchange rate result in operating exposures
different from the usual base case of revenues from abroad. Exchange
demand shifts and strategic interactions are affected by the relative s
profitability, and elasticities in the two product markets, and by the
competitive positions in each. Asymmetries in market characteristics a
competitive positions will increase the significance of the demand shif
strategic interaction terms relative to the base case for at least one of
two firms.
This section explores the significance of the demand shift and strategic
interaction terms, first with a general symmetry among firms and markets,
and then with various asymmetries intended to reflect some stylized facts
about U.S. firms and markets. Simple numerical examples, summarized in
Table 1, illustrate the effects on duopolists' exposures. Exchange rate
demand shifts are considered first.
Exchange Rate Demand Shifts
The demand shift terms in the duopolists' operating exposure reflect the
direct effect of an exchange rate shock on consumers and hence, prices, in
each country. For Firm 1 these terms are: qld($Pd/8S) and Sqlf(bPf/6S).
Many plausible stories about the effects of exchange rate shocks on
consumers imply: bPd/8S > 0 and bPf /6S < 0. This is consistent, for
example, with the hypothesized wealth effect described above. Under this
assumption, the two demand shift terms in a given firm's exposure have
opposite signs, but exactly offset each other only with a complete
symmetry of demand characteristics in each market.
To see that the magnitudes of the demand shift terms are significant,
consider Firm 1. The demand shift term associated with the foreign market,
Sqlf (bPf /bS), is negative; the base case exposure, Pfqf , is positive. If the
elasticity of Pf with respect to S is less than minus one, (S/Pf)(bPf/6S) < -1,
then the negative demand shift term is not only significant, but dominates
the positive base case exposure.
Now suppose the foreign country is "small" compared to the domestic
country and the direct effect of a shift in S on domestic country residents
is negligible. Then bPd/6S 0. If, at the same time, residents ill the
"small" foreign country are greatly affected so that (S/Pf)(8Pf/6S)<-1,
then the domestic firm's total exposure is negative: Pfqlf + qld(8Pd/6S) +
Sqlf(bPf/8S) <0. In other words, the base case exposure does not even
have the right sign. This occurs even in the absence of strategic effects; a
perfect competitor or monopolist would be subject to the same demand
shift and the resulting effect on exposure. Note that no assumption was
made about the relative importance to the firm of the two markets. Its sales
at home may dwarf those abroad or vice versa. Likewise, there has been no
assumption about the firm's competitor. It may or may not constitute a sig-
nificant presence in either or both markets. The result is driven by the shift
in foreign demand induced by a rise in S and the absence of an offsetting
shift in domestic demand.
TABLE 1
Numerical Examples
Domestic Price (domestic currency): Pd=al +a2S-a3q1d-a4q2d

Foreign Price (foreign currency): Pf =b1 +b2IS-b3qlf -b4q2f
Firm 1 costs (domestic currency): Cl =10+m(qld+qlf)2
Firms 2 costs (foreign currency): c2=10+n(q2d+q2f)2
Parameter Example 1 Example 2 Example 3

a1 400 200 700
a2 0 200 100
a3 1 1 1
a4 1 1 1
bl 400 200 300

b2 0 200 100
b3 1 1 1.5
b4 1 1 1.5
m 0.5 0.5 0.6
n 0.5 0.5 0.5
S 1 1 1
Firm 1 Firm 2 Firm 1 Firm 2 Firm 1 Firm 2

Outcomes
Pd 240 240 240 240 427.97 427.97
Pf 240 240 240 240 294.63 294.63
qid 80 80 80 80 178.21 193.82
q1f 80 80 80 80 29.92 40.33
Pro fit, 25,590 25,590 25,590 25,590 59,083 67,408
dq1dIdS 0.00 -53.33 66.67 13.33 32.27 -46.51
dq1fdS 53.33 0.00 -13.33 -66.67 36.04 -26.89
Exposures
Base Case 19,200 -19,200 19,200 -19,200 8,815 -82,949
DSId 0 0 16,000 16,000 17,821 19,382
DS1f 0 0 -16,000 -16,000 -2,992 -4,033
SITId 4,267 0 -1,067 -5,333 8,289 -6,255
SIT1f 0 -4,267 5,333 1,067 1,207 -2,180
Total Exp 23,467 -23,467 23,467 -23,467 33,140 -76,034
Notes: DSu denotes a demand shift component of ex
strategic interaction component for firm i in market j. Prices, costs and profits are expressed
in local currency. All exposures are expressed in foreign currency. Figures may not add
exactly due to rounding.
Strategic Interaction
The strategic interaction terms in Firm l's exposure (equation (7)) show how
Firm l's exposure depends on Firm 2's response to the exchange rate shock
in both markets. The terms are [qld(6Pd/&f2d)](dq2d/dS) and [Sq1f(6Pf/
&q2f)](dq2f/dS). For downward-sloping demand curves, these terms will
have signs opposite those of the derivatives of Firm 2's quantities wAith
respect to the exchange rate, dq21/dS. If Firm 2 responds to a rise in S by
expanding (contracting) output in a given market, then Firm l's positive
base case exposure is reduced (increased) by the corresponding negative
(positive) strategic interaction term.
As described above, Firm 2's response to the shock depends on whether
the firm's products are strategic substitutes or complements, whether the
markets display economies or diseconomies of scope, and on the strategic

denomination of Firm 2's output. The numerical examples that follow illus-
trate outcomes in a situation of strategic substitutes, joint diseconomies,
and positive local currency demand shifts (i.e., bPd/bS 2 0 and bPf /6S s 0).
Parameter values and outcomes for all the examples are summerized in
Tible 1. Strategic interaction terms are considered in isolation first, then
demand shifts and asymmetries are added.
Example 1: No Demand Shifts, No Asymmetries
Consider a simple system of linear demand and quadratic costs:"
Pd=al +a2S-a3qld-a4q2d, (13)
Pf =b1 + b2/S- b3qf - b4qZf (14)

c1= 10+m(qld+qlf)2 (15)
c2=10+n(q2+q2f)2, (16)
where Pd and cl are expressed in the d

the foreign currency. Parameters ak, bk,
constants. The variables Pi, ci, and qij
profit expressed in the local currency, given by equations (4) and (5).
Suppose initially that there are no exchange rate demand shifts, so that
a2=b2=O. Let a, =bl =400, a3=a4=b3=b4=1, and m=n=1/2. Let S=1.
Substituting:
P= 400-qV -q21, j=d,f
Ci= 10 +(1 2)(qid + qif)29 i= 192.
First-order conditions are given by the equations (6), and the cor
coefficient matrix is negative semidefinite, as required for
Equilibrium quantities are qld=qlf =q2d=q2f =80. Substituting in the
inverse demand functions gives prices: Pd = SPf = 240. The firms have base
case exposures with opposite signs and equal magnitudes: Pfqlf = 19,200
(Firm 1) and -Pdq2d/S=-19,200 (Firm 2).
For both firms, exports are strategically denominated in the local currency:
621/lqIf6S= 160>0 and 62w2/&i2dS=-160<0. In other words, Firm 1 's
marginal profit from exporting to the foreign market increases with a depre-
ciation of the domestic currency; Firm 2's marginal profit from exporting
to the domestic market decreases with a depreciation of the domestic
currency. Each firm's production for its home market has no strategic
denomination. These strategic denominations appear on the right-hand side
of the system of equations (10). Solving this system for each firm's
responses to an exchange rate shock gives:
dqId/dS= 0; dqIf/dS= 5
Firm 1 responds to a domes

in the foreign market (dq1f/dS= 53.33). Firm 2 responds by contracting its
output for the domestic market (dq2d/dS=-53.33). Neither firm changes
output for its home market. However, the export responses alone result in
significant strategic interaction terms. Let SITij denote the strategic inter-
action term associated with firm i's output in market j. For Firm 1:
SITld = [qlIdPd/62d*dq2d1d) = 4,267,
SITlf [Sqlf(Pf/J2fW)](dq2f/dS) = 0.
Firm l's exposure is the sum of its base case exposure and the SIT11:
E1 =PfqIf + [qI Pd/b2d)I(dq2dld)+ [Sq (fPf/&J2f)](dqf/dS)
= 19,200 + 4,267 + 0 = 23,467
Firm 2's exposure, multiplied by S, is given by the sum of its base case
and the SIT2j:
SE1 = -Pdq2d/S+ [q2dbdlId) I(dql ddS+ [Sq2P/&l)](dq/dS)
= -19,200 + 0 - 4,267 = -23,467.
In this case, strategic interaction terms do not affect the sign of either
firm's operating exposure. However, their magnitudes are quite significant.
Exposure increases by more than 20% over the base case even in this
perfectly symmetric example.
Example 2: Strategic Interaction and Demand Shifts, No Asymmetries
Now the assumption of no demand shifts is dropped. This affects exposure
directly, through the demand shift terms, and indirectly, through the depen-
dence of strategic denominations on the partials bPjF/S. Assume first that
the demand shifts are symmetric across markets and that the markets are
the same size. Let a, =a2 =b = b2= 200. Inverse demand curves are given by:
Pd=200+200S-qId-q1f,
Pf=200 + 200/S- qlf- q2f*
Equilibrium prices and quantities are the same as before: Pd = SPf = 240 and
qij= 80. Base case and total exposures are also the same, but the demand
shift and strategic interaction terms have changed considerably (see Table 1).
Both firms have demand shift terms of 16,000 associated with the domestic
market and exactly offsetting terms associated with the foreign market.
Previously, non-zero reoptimizations were associated exclusively with the

competitor's exports. In this example, there are strategic interactions associ-
ated with the competitor's home market production as well. Furthermore,
strategic interaction due to the competitor's exports previously reinforced
the base case exposure. Here, these terms have signs opposite to the base
case. The difference between the two examples is the change in strategic
denominations caused by the direct dependence of prices on the exchange
rate. Recall that strategic denominations (multiplied by -1) are given by the
right-hand side of system (10). This vector of strategic denominations has
changed from [0, -160, 160, 0]' to [-200, 40, -40, 200]'. For Firm 1,
the marginal profit associated with output for the home market is increas
by a depreciation of the domestic currency whereas previously it was
unaffected. At the same time, the marginal profit associated with Firm l's
exports now decreases rather than increases with a domestic currency depre-
ciation. Firm 2 realizes the (inverse of the) same effects.
Strategic denominations have switched from local to non-local currency, and
the firms's responses to the shock change as a result. Solving system (10)
for dPij/dS gives: dqld =66.67, dq1fdS=-13.33, dq2d=13.33, and dq2fdS=
-66.67. Now, when the firms reoptimize after a domestic currency depre-
ciation, Firm 1 contracts its exports and expands output for the domestic
market. Firm 2 similarly contracts at home in the foreign market and
expands abroad. For each firm, the derivative of total quantity with respect
to the exchange rate is the same (53.33 units) as in the first example (see
Table 1). However, for each market the derivative of total quantity with
respect to the exchange rate now has the opposite sign and a larger magni-
tude. The firms' responses in a given market reinforce rather than offset
one another.
This result depends on non-zero values for 6Pd/6S and 6Pf/6S, but does
not require extreme values for these partials. Note that the demand shift
components of exposure have lower magnitudes than base case exposure.
For Firm 1, for example, -(S/Pf)(6Pf/6S) <1, which does not seem
extreme. Similarly, the elasticity of foreign price with respect to the
exchange rate, -(S/Pf)(dPf/dS), is roughly 0.5, a quite reasonable magni-
tude for a pass-through coefficient. 12 Finally, note that the result occurs in
spite of the symmetries in market sizes, demand elasticities, and technolo-
gies. The result requires bPj/6S to be non-zero, but these particular value
for bPf/6S and bPd/bS are not crucial.
Example 3: Strategic Interaction, Demand Shifts and Asymmetries
Several asymmetries are now added. First, assume that demand in the
domestic market is both greater and more elastic than in the foreign market.
These changes are reflected by changes in the parameters a,, a2, and bk
(k= 1, . . ., 4). Assume further that Firm 1 is at a variable cost disadvan-
tage such that it pays 20% more per unit to manufacture good x than does
Firm 2. This is reflected by an increase in the parameter m. The new
inverse demand curves are:
Pd=700+I00S-qld-
Pf =300 + 100/S- I.
and cost curves are:
c1 = 10 + 0.6(qld + qlf )2
C2= 10 + 0.5(q2d + q2f )
Outcomes are summarized in Table 1. Both firms charge a higher price in

the domestic market than in the foreign market.13 Firm 1 has a lower
output share in both markets than in the previous examples, due to its vari-
able cost disadvantage. Firm l's base case exposure of 8,815.07 is much
lower than before because its revenues from the (smaller) foreign market
are so much lower. In contrast, Firm 2's base case of -82,949.15 is nine
times larger than Firm l's because the domestic market is so large.
The domestic market demand shift term in Firm l's exposure has the same
sign as its base case, but is twice as large, and is only slightly offset by
the foreign market demand shift. Meanwhile, because Firm 2 responds to
a domestic currency depreciation by contracting output both at home and
abroad, Firm l's value is even further enhanced by the depreciation. This
is reflected in its strategic interaction terms, which are both positive and
which together are larger than the base case. Total exposure, at 33,139.52,
is nearly four times the base case.
Firm 2, based in the smaller foreign market, has a base case that overstates
its total exposure, although by less than 10%. Although exposure is smaller
than the base case, it is large compared to profits. The asymmetries in the
example give Firm 2 an exposure that exceeds its profits. This is a numeri-
cal example of what Adler and Simon [1986] call "super-nominal" exposure.
Next, note that Firm 2 responds to a domestic currency depreciation by
contracting output in both markets, whereas Firm 1 responds with
increases in both. For each firm, the change in total output, d(qid + q(f)/d
exceeds the change observed in example 1, above. However, for each
market, the change in total output is significantly smaller than in examp
1 because competitors' responses in each market tend to offset one another
The pass-through coefficients, (S/Pf)dP/dS and (S/Pd)dPd/dS, have conven
tional signs (positive and negative, respectively) and are roughly equal to
0.3, indicating price changes that are much less dramatic than the change
in the exchange rate.
In summary, the combination of demand shifts, strategic interactions, and
asymmetries in this example result in both firms having large exposures
compared to the base case in a symmetric setting. Both firms also have
large quantity responses to the shock. Nevertheless, the change in output
in a given market is smaller than in the symmetric setting, and price
changes are, accordingly, modest. This is consistent with responses

observed in many U.S. product markets following the fall of the dollar that
begain 1985.
CONCLUSIONS
Global competition is characterized by large firms with market power

competing simultaneously in more than one product market. The inter-
national economy is characterized by consumers who are directly affected
by exchange rate changes, by markets that differ in their demand properties,
and firms that differ in their cost structures. Incorporating these features
of the economic landscape into a model of firms' operating exposure to
real exchange rate changes gives results that differ significantly from those
of simpler models. IWo sources of exposure arise from these features:
demand shift terms associated with each market and reflecting the effects
of an exchange rate shock on consumers; and strategic interaction terms,
one for each market and competitor, reflecting the dependence of exposure
on competitors' responses to an exchange rate shock. These components of
exposure may have different signs from base case exposure and they have
generally significant magnitudes even in highly symmetric settings.
Asymmetries across firms and markets tend to magnify their significance
for at least one competitor.
The demand shift components of exposure arise solely from allowing
prices in both markets to depend in a general way on the exchange rate.
They are linear functions of the partial derivatives of prices with respect to
the exchange rate, bPjF/S. They constitute a significant source of exposure
for any firm operating in a market for which this partial is non-zero. These
tenns do not depend on the type of competition in which firms are engaged.
Strategic interaction terms capture the feedback of one firm's reactions to
an exchange rate shock into its competitor's exposure. Such competitive
responses depend, in turn, on three factors: 1) whether the markets display
(dis)economies of scope; 2) whether the firms' products are strategic com-
plements or substitutes; and 3) the strategic denomination of the firms'
output, i.e., whether a shift in the exchange rate raises or lowers the
marginal profit associated with output for a given market. Further, as with
demand shift terms, strategic interaction terms depend on the partials
bPlbS because strategic denominations depend on them.
A particular market may be deemed by global competitors to be strate-
gically important in the sense that competitive positions in that market
significantly affect competitive positions elsewhere. The strategic signifi-
cance of a market may derive simply from its size if, for example, it is
large enough to be critical to a firm's ability to cover fixed costs. Signif-
icant asymmetries may arise from country size, market size, demand elas-
ticities, technology, etc. While these do not further complicate the
expression for operating exposure, they may greatly enhance or diminish
the importance of demand shifts and strategic interactions. Firms for which
the strategic market is "home" may have exposures that are especially sensi-
tive to competitors' responses in this important market.
The examples in the preceding section incorporated asymmetries corre-
sponding to stylized facts about some U.S. industries. Many U.S. markets
are quite large compared to foreign markets and it is frequently the case
that the U.S. market is more important to non-U.S. producers than non-
U.S. markets are to U.S. producers. The direct effects of exchange rate
changes on consumers in the U.S. are generally thought to be less than for
consumers elsewhere, and in many global industries U.S. producers are
thought to face a variable cost disadvantage compared to non-U.S. compet-
itors. In such a setting, U.S. firms can expect to have relatively smaller
base case exposures and relatively larger demand shift and strategic inter-
action terms. As a result, base case exposures become quite misleading
representations of total operating exposure.
NOT7ES
1. Operating exposure has also been called "economic," "real," or "competitive" exposure. It is distinct
from the ("contractual") exposure of contracts denominated in a particular currency, and from the
("translation") exposure arising from the need to report a firm's financial condition and results in a
common currency.
2. Shapiro [1975], p. 487.
3. For an illustration of the type of ambiguity shown in Choi [1986], see the discussion of excha
rate demand shifts in the first part of section four in this article. Flood and Lessard [1986] also d
the direct dependence of demand on the exchange rate, but do not model it formally.
4. Flood's "global competition" means something different from what is intended in this article. H
"increased global competition" connotes an increasing market share for non-local producers, wh
remain perfect or monopolistic competitors. In contrast, this article associates global competition
multimarket oligopoly.
5. A discussion of the causes of the globalization of competition in some industries is given in P

[1986].
6. It is also similar to the framework adopted by Sundaram and Mishra [1988a]. For a somewhat
different treatment of global competition, see Ghemawat and Spence [1986].
7. Sundaram and Mishra [1988b] further generalize the BGK model and demonstrate its versatility.
8. Another reasonable name for strategic denomination would be "strategic exposure," as it refers to
the exposure of the marginal profit schedule. However, "strategic exposure" has been used elsewhere,
for other purposes, and its use here might promote confusion.
9. Homogeneity contributes to conceptual simplicity, but is not necessary. Any goods that satisfy the
demand and cost curves given below are acceptable, as the model will not impose the law of one price
as a condition for equilibrium. Thansportation costs, for example, could be introduced as a formal justi-
fication for this, but would unnecessarily complicate the mathematics.
10. Firms 2's exposure is multiplied by S to express it in the same (foreign) currency as Firm l's expo-
sure.
11. As Sundaram and Mishra [1988b] point out, the functional forms adopted determine the strategic
linkages between firms and markets. Thus, outcomes in the numerical examples cannot be generalized
beyond the particular case of strategic substitutes, joint diseconomies, and positive local currency
demand shifts.
12. See Flood [1985] and sources cited therein on pass-through.

13. Obviously, this sort of cooperative price discrimination depends on foreign market customers being
prevented from remarketing output in the domestic market.
REFERENCES
Adler, F.M. & D. Simon. 1986. Exchange risk surprises in international portfolios. Journal of Portfolio
Management, Winter: 44-53.
Ankrom, R.K. 1974. lbp-level approach to foreign exchange rate problem. Harvard Business Review,
July-August.
Bulow, J.I., J.D. Geanakoplos & P.D. Klemperer. 1985. Multimarket oligopoly: Strategic substitutes and
complements. Journal of Political Economy, 93(3): 499-511.
Choi, J.J. 1986. A model of firm valuation with exchange rate exposure. Journal of International Busi-
ness Studies, Summer: 153-60.
Dufey, G. 1972. Corporate finance and exchange rate variations. Financial Management, Summer: 51-
Flood, Jr., E. 1985. Global competition and exchange rate exposure. Research Paper #837, Graduate
School of Business, Stanford University, September.
-- & D.R. Lessard. 1986. On the measurement of operating exposure to exchange rates: A concep-
tual approach. Financial Management, Spring: 25-36.
Ghemawat, P. & A.M. Spence. 1986. Modelling global competition. In M.E. Porter, ed., Competition
in global industries. Boston: Harvard Business School Press.
Hekman, C.R. 1985. A financial model of foreign exchange exposure. Journal of International Business
Studies, Summer: 83-99.
Lessard, D.R. & J.B. Lightstone. 1986. Volatile exchange rates can put operations at risk. Harvard Bu
ness Review, July-August: 107-14.
Levi, M. 1983. International finance. New York: McGraw-Hill.

Porter, M.E. 1980. Competitive strategy. New York: Free Press.
. 1986. Competition in global industries: A conceptual framework. In M.E. Porter, ed., Compe-
tition in global industries. Boston: Harvard Business School Press.
Shapiro, A.C. 1975. Exchange rate changes, inflation, and the value of the multinational corporation.
Journal of Finance, 30(2): May: 485-502.
Sundaram, A. & V. Mishra. 1988a. Currency movements and corporate pricing strategy. Working Paper
No. 207. Amos TUck School of Management, Dartmouth College. September.
. 1988b. Strategic substitutes and complements, demand and cost functions and generalized con-
jectures: An exploration of linkages. Working paper. Amos Tuck School of Management, Dartmouth
College. September.

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The Exchange Rate Exposure of a Global Competitor

Author(s): Timothy A. Luehrman

Abstract. This paper analyzes the exposure of operating cash

The international economic environment is presently characterized by vola-

*Timothy A. Luehrman is Assistant Professor of Business Administration and a

The value of expected future operating cash flows depends on r

Many executives immediatel

MODEL OF A GLOBAL COMPETITOR'S EXPOSURE

Definition of Operating Exposure

Operating exposure is defined as the derivative of firm value with respect

A global competitor is distinguished by its coordination of internationally

a change in relative prices. Firms reoptimize accordingly. Prices in each

Pd = Pd(qId, q2d 5) (1)

Pfl=jPf(qIf q2f S) (2)

Pj = price of good x in market j, expressed in

ci = Iqqd +qif)s i=1, 2 (3)

where cl and c2 are expressed in domestic and for

W2 = (/S)Pdq2d +Pf q2f -c2, (5)

where wr and 'r2 are expressed in domestic and foreign curren

67r /Ild = 67r /&If = 672/&2d = b72/&I2f = 0 (6)

Firm l's exposure is obtaine

dir /dS= Pf q1f+ qd(6P

Similarly differentiating 'r2 with respect to S and simplif

d7r2/dS = -(1 /S2)Pdq2d + (1 IS)q2d(6Pd/6S) + q2$bPf/6S)

+ [q2f(6Pf /&1f)](dq1f /dS). (8)

(627 lbq jaId)dqId + (62ir1/&J1qIf)dq1f+ (6b2w/716dq2d)dq2d

+ (62 w/ .6qZf)dqZf+ (62r1 /&ljI5S)dS = 0. (9)

where A is the matrix of second par

Premultiplying both sides of equation (11) by the inverse of the coefficient

dq1/dS=A11_1[b1 -A12(dq21/dS)], (12)

ASYMMETRIES AND NUMERICAL EXAMPLES

Exchange Rate Demand Shifts

Domestic Price (domestic currency): Pd=al +a2S-a3q1d-a4q2d

Parameter Example 1 Example 2 Example 3

bl 400 200 300

Firm 1 Firm 2 Firm 1 Firm 2 Firm 1 Firm 2

markets display economies or diseconomies of scope, and on the strategic

Pd=al +a2S-a3qld-a4q2d, (13)

Pf =b1 + b2/S- b3qf - b4qZf (14)

where Pd and cl are expressed in the d

P= 400-qV -q21, j=d,f

Ci= 10 +(1 2)(qid + qif)29 i= 192.

Firm 1 responds to a domes

SITld = [qlIdPd/62d*dq2d1d) = 4,267,

E1 =PfqIf + [qI Pd/b2d)I(dq2dld)+ [Sq (fPf/&J2f)](dqf/dS)

= 19,200 + 4,267 + 0 = 23,467

SE1 = -Pdq2d/S+ [q2dbdlId) I(dql ddS+ [Sq2P/&l)](dq/dS)

= -19,200 + 0 - 4,267 = -23,467.

Pf=200 + 200/S- qlf- q2f*

Previously, non-zero reoptimizations were associated exclusively with the

and cost curves are:

C2= 10 + 0.5(q2d + q2f )

Outcomes are summarized in Table 1. Both firms charge a higher price in

changes are, accordingly, modest. This is consistent with responses

Global competition is characterized by large firms with market power

2. Shapiro [1975], p. 487.

5. A discussion of the causes of the globalization of competition in some industries is given in P

12. See Flood [1985] and sources cited therein on pass-through.

Levi, M. 1983. International finance. New York: McGraw-Hill.