Module 3.

Management of Economic Exposure

Chapter 9

Massey University | massey.ac.nz | 0800 MASSEY

Outline
▪ Economic exposure defined
▪ How to measure economic exposure
▪ How to manage economic exposure
▪ Determinants of operating exposure
▪ How to manage operating exposure
▪ FX exposure: hedge or not to hedge?
Economic Exposure Defined
Economic exposure is the sensitivity of the home
currency value of a firm’s asset, liability and operating
cash flow to the unexpected changes in FX rates.
➢ This is the exchange rate risk applied to a firm’s
competitive position.

⚫ Even a purely domestic firm may be subject to

foreign exchange exposure if its products compete
with imported goods.
How to Measure Economic Exposure
Economic exposure can be measured by the exposure
coefficient (b), which is the sensitivity a firm’s home-
currency value (P) of assets/liabilities/operating cash
flow to changes of the exchange rate (S = Sh/f).

Suppose Var(P) = b 2 × Var(S) + Var(e),

⚫ Estimate b using regression: P = a + b × S + e

Cov(P,S)
⚫ Estimate b using formula: b=
Var(S)
Exposure of U.S. industry portfolios to the dollar exchange
rates: 2000-2018
Forex
Industry Market Betab
Betac
1. Aircraft, ships, and railroad equipment 1.015 0.030
2. Apparel 0.971 ‒0.181
3. Automobiles and trucks 1.385 ‒0.229
4. Banking, insurance, real estate, trading 1.073 0.089
5. Beer and liquor 0.351 −0.224
6. Business equipment 1.513 0.133
7. Business supplies and shipping containers 0.883 −0.234
8. Chemicals 1.094 −0.413*
9. Coal 1.082 −1.738*
10. Construction and construction materials 1.161 −0.255
11. Consumer goods 0.488 −0.058
12. Electrical equipment 1.275 −0.372*
13. Fabricated products and machinery 1.382 −0.342*
14. Food products 0.446 −0.238*
15. Health care 0.644 0.306*
Recall that in the study of risk-return relationship
using the CAPM, the sensitivity of a stock’s return to
stock index movement can be estimated using
regression analysis:
ri = rf + bi ×rm + e

The total risk of a stock is decomposed into two parts:

Risk of stock return = systematic risk + unique risk
Var(ri) = bi 2 × Var(rm) + Var(e)
Decomposing the Economic Exposure
Similarly, the volatility (variance) of the home-
currency value (P) of assets/liabilities/operating cash
flow can be decomposed into two parts:
Var(P) = b 2 × Var(S) + Var(e)
⚫ the first part “b 2 × Var(S)” quantifies the volatility
due to the foreign exchange rate movement,
⚫ the second part “Var(e)” is the volatility induced by
factors other than the foreign exchange rate
movement.
Example: A U.S. company has an asset in France.
There are three states of the world which are equally
likely to occur. The future local currency price of this
French asset (P*) and the future exchange rate (S) will
be depending on the realized state of the world.

Scenario 1 - P* and S are negatively correlated:

State Probability P* S P = S×P*
1 1/3 €1,000 $1.40/€ $1,400
2 1/3 €933 $1.50/€ $1,400
3 1/3 €875 $1.60/€ $1,400

➢ P is not affected by FX rates, there is no exposure.

Scenario 2 - P* and S are positively correlated:
State Probability P* S P = S×P*
1 1/3 €980 $1.40/€ $1,372
2 1/3 €1,000 $1.50/€ $1,500
3 1/3 €1,070 $1.60/€ $1,712
 State Probability P* S P = S×P*
1 1/3 €980 $1.40/€ $1,372
2 1/3 €1,000 $1.50/€ $1,500
3 1/3 €1,070 $1.60/€ $1,712

To quantify the size of the foreign asset’s economic

exposure using formula,
Step 1: Estimate the weighted average of S and P:
S = 1/3 × ($1.40/€ + $1.50/€ + $1.60/€) = $1.50/€
P = 1/3 × ($1,372 + $1,500 + $1,712) = $1,528
Step 2: Estimate Var(S) and Cov(P,S):
Var(S) = 1/3 × [($1.40 /€ – 1.50/€)2 + ($1.50/€ – $1.50/€)2
+ ($1.60/€ – $1.50/€)2] = 0.02/3($2/€2)
Cov(P,S) = 1/3 × [($1,372 – $1,528) × ($1.40/€ – $1.50/€)
+ ($1,500 – $1,528) × ($1.50/€ – $1.50/€)
+ ($1,712 – $1,528) ($1.60/€ – $1.50/€)]
= 34/3 ($2/€)

Step 3: Calculate the exposure coefficient b:

b = [(34/3) ($2/€)] / [(0.02/3) ($2/€ 2)] = €1,700

How to protect the company’s exposure to FX risk?

Example: Financial Hedging
At T = 0, sell €1,700 forward. Suppose F = $1.50/€.

At T =1 Cash sale: Forward gain/loss

P* S1($/€)
€980 × $1.40/€1 = $1,372 €1,700×($1.50/€ - $1.40/€)=$170
Total = $1,542
€1,000 × $1.50/€1 = $1,500 $0
Total = $1,500

€1,070 ×$1.60/€1 = $1,712 €1,700×($1.50/€ -$1.60/€)=-$170

Total = $1,542
The forward hedging reduces, but does not eliminate,
the foreign exchange risk in this case.

⚫ Var(P) = 1/3 × [(1,372 – 1,528)2 + (1,500 – 1,528)2

+ (1,712 – 1,528)2] = 19,658.67($2)
⚫ b 2×Var(S) = 1,7002× (0.02/3) = 19,266.67($2)
19,266.67 / 19,658.67 = 0.98,
➢ only 98% of the variation in the French asset’s US$ price
is caused by FX uncertainty.
⚫ The 2% residual variation in P is caused by factors other
than FX uncertainty: Var(e) = Var(P) - b 2 × Var(S).
 Scenario 3 - P* is a constant, not correlated with S:
State Probability P* S P = S×P*
1 1/3 €1,000 $1.40/€ $1,400
2 1/3 €1,000 $1.50/€ $1,500
3 1/3 €1,000 $1.60/€ $1,600

⚫ Exposure coef. = 1,000

⚫ FX uncertainty explains 100% of the variation in the
US$ price of the asset. A perfect hedge is possible.
Example: a Perfect Financial Hedging
At T = 0, sell €1,000 forward at F = $1.50/€.
At T =1 Cash sale: Forward gain/loss

P* S1($/€)
€1,000 × $1.40/€1 = $1,400 €1,000×($1.50/€ - $1.40/€)=$100
Total = $1,500
€1,000 × $1.50/€1 = $1,500 $0
Total = $1,500

€1,000 ×$1.60/€1 = $1,600 €1,000×($1.50/€ -$1.60/€)=-$100

Total = $1,500

➢ The forward hedging eliminates 100% of FX risk.

Operating Exposure Defined
The operating cash flow in home-currency may change
following a foreign exchange rate movement due to:
⚫ Competitive effect.
⚫ Conversion effect.

Operating exposure is the extent to which the firm’s

operating cash flows will be affected by random
changes in the exchange rates - an economic exposure
arising from business operation
⚫ can be measured using sensitivity analysis.
Determinants of Operating Exposure
A firm’s operating exposure is determined by:
⚫ The structure of the markets in which the firm
sources its inputs, such as labor and materials, and
sells its products.
⚫ usually subject to high degrees of operating exposure
when either its cost or its price is sensitive to FX rates.
⚫ when both the cost and the price are sensitive or
insensitive to FX rates, operating exposure is low.
⚫ The firm’s ability to mitigate the effect of exchange
rate changes by adjusting its markets, product mix,
and sourcing.
How to Manage Operating Exposure
Objective of managing operating exposure is to
stabilize cash flows in the face of fluctuating exchange
rates
Strategies for managing operating exposure:
⚫ Selecting low-cost production sites.
⚫ Flexible sourcing policy.
⚫ Diversification of the market.
⚫ Product differentiation and R and D efforts.
⚫ Financial hedging.
Example: Hedging Policy of FPA
Enters into a variety of derivative financial instruments to
manage its exposure to foreign exchange rate risk and
interest rate risk including forward foreign exchange
contracts, interest rate swaps and options.
Hedge:
⚫ net receipts and net payments in US$

⚫ significant capital expenditure transactions

⚫ finished products manufactured in Thailand and Mexico.

⚫ highly probable forecasted purchases and receipts for up

to two years.
FX Exposure: Reasons not to Hedge

Arguments against hedging:

⚫ Firm hedging may not add to shareholder wealth if
shareholders can manage the exposure themselves.
⚫ Hedging may not reduce a firm’s systematic risk
and well-diversified shareholders may not benefit.

In practice, many MNCs hedge with forward, swap

and options.
FX Exposure: Reasons for Hedging
Argument for hedging: there are market imperfections.
⚫ Information asymmetry: debtors, suppliers and
customers prefer stable cash flows.
⚫ Differential transaction costs.
⚫ Costs of default: hedging may reduce the cost of
capital if it reduces the probability of default.
⚫ Taxation under progressive tax rates: total taxes are
higher for “boom and bust” earnings stream; pay less
taxes by smoothing out earnings using hedging.
Translation vs. Transaction Exposure
Translation exposure is an accounting issue, while
transaction exposure is a finance issue.
⚫ Most firms reduce transaction exposure first.
⚫ Then decide if any residual translation exposure can
be reduced without creating more transaction
exposure.
Side Effect of Hedging Translation Exposure
⚫ Balance sheet hedge: eliminate the mismatch between
assets and liabilities denominated in the same
currency by creating new exposed assets or liabilities.
➢ May create transaction exposure.
⚫ Derivatives hedge (off-balance-sheet hedge).
➢ May affect income statement.

❖ It is generally not possible to eliminate both

translation exposure and transaction exposure.
When to Hedging Translation Exposure

It makes sense to hedge translation gains or losses if:

⚫ an exposure will realize soon through asset sale or
liquidation.
⚫ an exposure weakens financial ratios and violates a
debt covenant.
⚫ an exposure is a result of hyperinflation while a
significant deflation is unlikely to happen.
Homework:
Questions: 4, 8.
Problems: 1, 2, 3.

Next week:

International money and capital markets:

Chapters 11 (p281-298 only), 12 and 13.