Assessing Exchange Rate

Risk: Part II

Exchange Rate Exposure

 www.blades.com

BLADES Board & Skate arrived on

the action / extreme scene in 1990, and
quickly became a trusted source of
equipment and service to in-line
skaters, skateboarders, and
snowboarders.

BLADES got its start in New York and currently

operates 15 retail stores in New York, New Jersey,
Massachusetts and Pennsylvania.
 Blades could cut costs by
importing lower cost
components from Thailand

Increasing competition
and rising costs have
lowered Blades’ profit
margins
Suppose that Blades makes an agreement to buy plastic
components sufficient to produce 72,000 pairs of
rollerblades from Thai manufacturers at a price of
THB 2,870 per pair. ($1 = THB 38.87). Payment is due
in one month (72,000*2,870 = THB 206.64 M)

Trend
 Should Blades import components from
Thailand?

$75 Per Pair THB 2,870 per pair

(THB 1
= $ .0257)
At the current
exchange rate,
Blades could cut
THB 2,870 (.0257) = $73.75
their costs by 1.6%
by importing from
Thailand (a savings
of $90,000)!! $75 - $73.75
100 = 1.6%
$75
 However, importing Thai components
creates a transaction exposure for Blades

THB 2,870 per pair

(THB 1 = $ .0257)

Costs ($) = e ($/THB) * 72,000* Costs (THB)

Random Constants
Variable

We need to
estimate this!!
 Regression Results

Variable Coefficients Standard Error t Stat

Intercept . 80 .02 40
Inflation .80 .35 2.28

Regression Statistics

R Squared .43
%e  a  b    *  
Standard Error 2.20

Observations 240

Every 1% difference between US inflation and Thai

inflation depreciates the dollar by .8%
 US inflation is currently 1% (per month) while
inflation in Thailand is 2.25% (per month)
(1 – 2.25) = -1.25

% Change in e =.8 + 0.80 * (inf) + error

($/THB)

Mean = . 80 Mean = .80 Mean = 0

Std. Dev. = .02 Std. Dev. = . 35 Std. Dev. = 2.20

StdDev  (.02) 2  (.35) 2 (1.25) 2  (2.20) 2  2.25%

Forecast Your 95% confidence

interval for the (monthly)
Mean = -.2%
percentage change in the
Std. Dev. = 2.25% exchange rate is
[-4.7% , 4.3% ]
 Assessing transaction exposure THB 2,870 per pair

(THB 1
= $ .0257)
Costs ($) = e ($/THB) * 72,000*2,870 THB

Forecast (% Change) Costs

Mean = -.2%
Mean = 72,000*2,870*.0257(1-.002)
Std. Dev. = 2.25%
= $5,300,026
Std. Dev. = .0225*72000*2870*.0256
= $119,250 (2.25%)
 Assessing transaction exposure THB 2,870 per pair

(THB 1
= $ .0257)
Costs ($) = e ($/THB) * 72,000*2,870 THB

Mean = $5,300,026
You are 95% sure your costs will
Std. Dev. = $119,250
be between:
$5,300,026 + 2*$119,250 = $5,538,526
and
$5,300,026 - 2*$119,250 = $5,061,526
 Should Blades import components from
Thailand?

$75 Per Pair THB 2,870 per pair

(THB 1
= $ .0257)
Mean = $5,400,000 Mean = $5,300,026
Std. Dev. = $0 Std. Dev. = $119,250

What do you do?

Blades is also thinking
about exporting
rollerblades to Thailand
Suppose that Blades makes an agreement to sell 30,000
pairs of roller blades to a Thai sporting goods store for
THB 4,500 apiece.

Trend
 Assessing transaction exposure

Net Cash Flows($) = e ($/THB) * ( 72,000*2,870 - 30,000*4,500)

= e ($/THB) * ( 71,640,000THB)

Forecast (% Change) Net Cash Flows($)

Mean = -.2%
Mean = 71,640,000*.0257(1-.002)
Std. Dev. = 2.25%
= $1,837,465
Std. Dev. = .0225*71,640,000*.0257
= $41,342 (2.25%)
Blades could also import
Japanese components.
Japanese components are
slightly more expensive
(Y 8,000 per pair = $74.77)

$1 = Y 107
Suppose that Blades splits its purchases
of components between Thailand and
Japan (Exports to Thailand = 0)

THB 2,870 per pair

THB 2,870*.0257*36,000 = $2,655,324
(THB 1
= $ .0257)
JPY 8,000*.0093*36,000 = $2,678,400
JPY 8,000 per pair $5,333,724
(JPY 1 = $ .0093)
 Forecast (% Change) Forecast (% Change)
Mean = 0% Mean = 0%
Std. Dev. = 2.25% Std. Dev. = 3.50%

CORR = -.65

$2,655,324 $2,678,400
= .49 = .51
$5,333,724 $5,333,724

Net Cash Flows

Mean  $5,333,724
SD   .49 2  .0225 2  (.51) 2 (.035) 2  2(.49)(.51)(.0225)(.035)(.65)  .014  1.4%
 And the Currencies Currency
Cash flow Situation… are… exposure
Equal Inflows of Two
Currencies Positively Correlated High
Equal Inflows of Two
Currencies Uncorrelated Moderate
Equal Inflows of Two
Currencies Negatively Correlated Low
Inflow in one currency/outflow
in another Positively Correlated Low
Inflow in one currency/outflow
in another Uncorrelated Moderate
Inflow in one currency/outflow
in another Negatively Correlated High

Importing from both Japan and Thailand can diversify

currency exposure!!
Suppose that Blades is planning to expand sales into
England. Should they try and contract sales in dollars
or Pounds?
Current Forecast (% Change)
GBP 1 = $1.80 Mean = 0
SD = 2.0%

Contracting sales in GBP creates transaction

exposure. However, contracting sales in USD creates
economic exposure
Suppose that Blades agrees to sell roller
blades to England for $125 apiece. (GBP 70)

Current Forecast (% Change)

GBP 1 = $1.80 Mean = 0

SD = 2.0%

Demand in England is as follows:

P = Local price of
Q = 400 - 3P Roller blades

At a local price of GBP 70, demand equal 500 - 3(70) = 190

 Q = 500 – 3P

P
Qd
%Qd Qd Qd P
d   
1% %P P P Qd
70 P

1.1%
# Roller Blades
190

Elasticity of Demand refers to Qd P  70 

the responsiveness of demand d   3   1.11
to price changes (here, the price P Qd  190 
is the interest rate)
Suppose that Blades agrees to sell roller
blades to England for $125 apiece. (GBP 70)

Current Forecast (% Change)

GBP 1 = $1.80 Mean = 0

SD = 2.0%

Revenues = Price ($) * Quantity

Forecast (% Change)
Constant
Mean = 0

SD = 2.0%*Elasticity = 2.2%
GBP Pricing (Transaction Exposure)

Revenues = e ($/L)* Price (L) * Quantity

Forecast (% Change)
Mean = 0 Constant
SD = 2.0

USD Pricing (Economic Exposure)

Revenues = Price ($) * Quantity

Forecast (% Change)
Constant
Mean = 0

SD = 2.0%*Elasticity = 2.2%
Changes in currency prices can have all kinds of
economic impacts. A more general way to estimate
economic exposure would be as follows:

PCFt  a  bet   t

Percentage change in cash Percentage change in the

flows (measured in home exchange rate ($/F)
currency)
 Regression Results
Variable Coefficients Standard Error t Stat
Intercept .05 1.5 .03
% Change in
Exchange Rate -3.35 .97 -3.45

Regression Statistics

R Squared .63 PCFt  a  bet  

Standard Error 1.20

Observations 1,000

Every 1% depreciation in the dollar relative to the British

pound lowers cash flows from England by 3.35%
 Suppose that Blades sets up a Thai
subsidiary. The Thai plant uses
locally produced components to
produce roller blades that will be
sold to local (Thai) customers.

Is Blades still exposed to currency risk?

Blades will need to produce consolidated cash flow and income
statements as well as a consolidated balance sheet. Translation
exposure refers to the impact of exchange rate changes on these
financial statements.

FASB Rule #52 (for US Based MNCs)

The functional currency of an entity is the currency of the economic
environment in which the entity operates
The current exchange rate as of the reporting date is used to translate
assets/liabilities from the functional currency to the reporting currency
The weighted average exchange rate over the relevant reporting period
is used to translate revenues, expenses, gains, and losses
Translated Gains/Losses are not recognized as current net income, but
are reported as a second component of stockholders’ equity

Should we be worried about this type of

exposure??
Examples of translation
exposure

Company Citigroup General Wall Mart

Motors
Net Income (2004) $17.04B $3.8B $9B

Income $731M $929M $320M

Gains/Losses due (4.3%) (24%) (3.5%)
to currency
changes