Corporate Exposure to Exchange Rates

Transcription

1 International Finance Spring 999 Prof. Gordon Bodnar Corporate Exposure to Exchange Rates Definitions Broadly speaking, we can classify the impact of exchange-rate changes on the firm into three effects: Translation Exposure: This measures the accounting derived exchange rate gains or losses that result from the need to convert foreign currency financial statements of affiliates into parent currency units. It arises from the total change in the nominal exchange rate from the previous reporting period and the particular accounting basis (defined by the consolidation method used). As this gain or loss is unrealized, translation effects do not result in a change in current cash flow and not justifiable to manage from a cash flow perspective, except in limited cases. Transaction Exposure: This exposure measures the change in the value of outstanding nominal financial obligations incurred prior to a change in the exchange rate but not due to be settled until after the exchange rate change. This is a result of only the unexpected component of nominal exchange-rate changes. Transaction exposures have an impact on current cash flows. Operating Exposure: This exposure measures the changes in cash flows from future transactions of the firm resulting from changes in real exchange rates and corresponding changes in relative competitiveness. Translation Exposure - The source of this exposure is examined in previous class note (optional). It arises from the accounting rules used to convert foreign currency financial statements into parent currency for consolidation. Transaction Exposure - Transaction exposure arises from unexpected changes in nominal exchange rates when:. Purchasing/selling goods or services on credit with foreign currency prices.. Borrowing or lending funds when repayment is to be made in a foreign currency. 3. Otherwise acquiring contractual nominal positions denominated in foreign currency. Example : Sale of Goods on Credit A U.S. firm sells goods to a foreign buyer with price of $0,000, with payments due in 90 days. The current spot price is S(FC/$) = 3.00, so the price of the sale in foreign currency is FC 30,000. The transactional exposure arises because in all likelihood the foreign buyer will not probably pay FC 30,000 because the spot rate will differ on the settlement date Consider: if S(FC/$) t+90 = 4 the foreign buyer pays FC 40,000 if S(FC/$) t+90 = the foreign buyer pays FC 0,000 Thus, the foreign buyer faces an economic gain or loss on the purchase of the good depending on how the exchange rate changes. Notice that if the contract price had been set in foreign currency, then the U.S. producer would face the transaction exposure rather than the foreign buyer. FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p.

2 Example : Borrowing in Foreign Currency: A UK firm borrows SF00,000 from a bank for year. At the time of the borrowing, S(SFr/ ) = 0, so UK firm borrowed 0,000. Ignoring the interest payments at the time of the repayment of principal: if S(SF/ ) =, the pound cost of repayment of principal = 8,333 and the firm experiences a gain of,666 if S(SF/,) = 8, the pound cost of repayment of principal =,500 and the firm experiences a loss of,500 Thus, the UK firm faces an exchange rate gain or loss (in pounds) depending on the change in the (SF/ ) nominal exchange rate. It should be noted that transaction exposure arises in every international transaction. Either the buyer or the seller will face a transaction exposure. Both will face transaction exposure if they contract in a third currency. Thus part of the negotiation of international transaction will include the currency of payment and which party will bear the transaction exposure. Ideally, the party best able to bear (manage) the risk will find it in their interest to take on the transaction exposure. In doing so, presumably, they can negotiate a slightly better deal out of the counterparty. Differences between Economic and Accounting Transaction Exposure Transaction gains or losses result in changes in actual cash flows. In this sense transaction exposures are cash flow exposures that directly impact firm value. However, the economic measure of transaction exposure differs in two important ways from the accountants measure of transaction exposure that we discussed previously and demonstrated above. The first difference between the economic transaction exposure and the accounting transaction exposure is the timing of the exposure. Economically the transaction exposure arises the moment the firm enters a FIXED NOMINAL FOREIGN CURRENCY CONTRACT. That is, whenever it commits to pay or receive a specific amount of foreign currency as part of a transaction at some date in the future. Thus, the economic exposures begins not when the transaction is entered into the books (typically when the good is shipped to or received by the buyer) but when the agreement is reached and the terms set for the transaction to occur. This date is typically called the commitment date. The economic definition of transaction exposure differs from the accounting definition in that the actual cash flow impact of exchange rate changes on the value of the transaction begin from the commitment date rather than the transaction date (which is when the accountants enter the transaction into the books). A second difference is the definition of exchange rate change that generates the gain/loss on an economist s measurement of transaction exposure compared to the exchange rate change that generates the gain/loss on the accountants measurement of transaction exposure. Under the accountant s definition, the transaction is originally recorded a the spot exchange rate on the transaction date and closed using the exchange rate on the settlement date. Thus, the exchange rate gain/loss is a function of the total nominal exchange rate change between these two dates. However, from an economic standpoint, this makes no sense. If I am setting a price today in foreign currency, knowing that I will not receive/pay foreign currency for say, ninety days in the future, why would I worry about the current exchange rate? I should be making my pricing decision based upon the expected value/cost of the transaction in 90 days. Thus, my decision regarding this transaction should be based upon my expectation of the exchange rate in 90 days not upon the current exchange rate. Put another way, I should be taking into account all the exchange rate change expected to occur between now and the settlement date when deciding on the price with which I will enter into the transaction. Ultimately I am concerned about the amount I am expecting to receive/pay on settlement, not how much the transaction is worth today. It is the present value of the expected cash flow that matters for firm value, not the value of that foreign currency cash flow at today s spot rate. The spot rate is irrelevant as the cash flow is not occurring today. Thus the second important difference is that economic transaction exposure is based upon UNEXPECTED nominal exchange rate changes not the actual nominal exchange rate changes as the accountants measure it. FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p.

3 Example: A U.S. firm agrees on September to a contract to provide a specialized computer chip to an Italian firm. The agreement specifies that the U.S. firms must provide build and ship 000 of these made-to-order chips within 80 days and that the Italian firm will make payment to the U.S. firm in the amount of Lit.5b within 80 days of receiving the chips. The current exchange rates are S(Lit/$) t = 00, S(Lit/$) t+80 = 50 and S(Lit/$) t+360 = 400 What is the value of this transaction to the U.S. firm? The U.S. firm will receive Lit.5b in 360 days. The current value of this inflow is the present value of Lit.5b x S($/Lit400) = $.786m Note that this expected value has nothing to do with the current spot rate nor the exchange rate on the transaction date. The transaction exposure the U.S. firm faces is the difference between the this amount $.786m and the amount of dollars they actually receive which will be Lit.5b times the actual spot rate on the settlement date. Thus the economic transaction exposure arises from the date that the Lit price is set (September ) and the size of the transaction gain or loss will be the product of Lit.5b and the deviation of the actual S(Lit/$) rate in 360 days from the expected S(Lit/$) rate in 360 as of September. The important managerial implication of this point is that when setting the foreign currency contract price, the firm should not be concerned about the current spot price, but rather the expected future spot price when it receives/makes payment in foreign currency. The firm should take into account any expected change in the nominal exchange rate in determining the expected revenue/cost associated with the contract. Given the expectational equilibrium in the market the expected future spot price is approximated by the forward rate. Thus the firm should be making international pricing decisions off of the forward rate curve and not off of the spot rate. Summary for Transaction Exposure If you are holding a foreign denominated net asset position, you gain from an unexpected depreciation of the home currency If you are holding a foreign denominated net liability position, you gain from an unexpected appreciation of the home currency. Operating Exposure The effects of operating exposure are more important for the financial position of the firm than the effects of transaction exposure. However, unlike transaction exposure, which are easily identified (directly form looking at the transaction contracts), operating exposure is somewhat subjective: it depends on assessing the impact of exchange-rate changes on transactions that have yet to be entered into. To determine operating exposure it is necessary to measure the change in the expected future cash flows of the firm in response to changes in the exchange rate. Since prices have not been set for future transactions, operating exposure depends not on changes in nominal exchange rates, but on changes in real exchange rates. As with transaction exposure, operating exposure should only be a function of unexpected changes in the real exchange rate as expected changes should be incorporated into current expectations about future firm performance (i.e. current market valuation). However, under relative PPP the expected change in the real exchange rate is zero. Under absolute PPP, the change in the exchange rate is determined by its movement back towards the assumed equilibrium. But this typically happens slowly, unless there is large sudden devaluation. However, to the extent that deviations from PPP are expected to cause real exchange rate changes over the medium term, the firm should incorporate these expectations into its pricing, production, and location decisions and be prepared for such movements. It is important to be aware that just about every firm conceivably has some operating exposure to exchange rates. The size and sign of a firm s operating exposure will be a function of several factors: the activities it participates in, such as exporting, importing, foreign investments etc., the nature of the competition it faces, such as a perfectly competitive output market or an oligopolistic output market where firms have some market power, and the structure of the markets FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p. 3

4 for its factors of production. However, it is impossible to generalize how all these factors interact to determine exposure. Therefore, to begin, let us consider a simple situation where firms produce homogeneous goods in a competitive international market with non-traded locally sourced inputs. In this case, the quantity sold won t matter as the markets are perfectly competitive and the quantity of any given firm is indeterminant and we can take it to be. This case will also clearly demonstrate the difference between short run and long run effects, which are more difficult to see in a more realistic model. To make the operating exposure clear, assume that all transaction are carried out on a cash at transaction basis, so transaction exposure is non existent. Operating Exposure in Simple Competitive Example Initially assume the price of foreign currency (FC) in terms of home currency (HC) is S(HC/FC) =.0 Consider a home country exporting firm that produces a homogeneous good the world-market determined price of the good is FC 0 => local price is HC 0 the firm has a HC cost of production (consisting of labor and inputs) of HC 9 net cash flow to the firm is HC the required rate of return to this activity is 0% the home country price level is.00 foreign firms produce the same good at a cost of FC 9 and have the same required rate of return there are no barriers to trade and transportation costs are zero Home firms that sell their good in the foreign market will be called exporters. Firms that sell their good in the home market will be called import competitors (a firm that competes in the home market with the imports from foreign firms). If the home firm exports its good, it sells the good for FC 0 which it converts into HC 0 at the current exchange rate of S(HC/FC) =. If it sells in the home market, then it sells its good for HC 0. In either case, with costs of HC 9 the firm makes a net cash flow of HC and its firm value is V 0. With this cash flow expected into perpetuity and no expected inflation the value of the firm given the required rate of return (0%) V 0 is 0, and the real value of the firm, V 0 /P 0 = 0. Now consider the effect of an unexpected 0% depreciation of the HC. the exchange rate rises to S(HC/FC) =.. What will be the impact on the firm value of the exporting firms in this industry? with competitive markets and unchanged foreign costs, the price for the good is still FC 0 when the firm sells a good at FC 0 and converts into HC it now receives with home country costs of production still at HC 9 (in the short run), the cash flow to the firm rises to HC raising firm value to V (V > V 0 ) with no inflationary expectations, and current cash flows the firm value, V rises to 0, and real firm value also rises (not quite to 0 as there has been some price level increase already). Since a firm is free to it sells its good in either the home or foreign market, this implies that the returns to selling at home must also rise. Before foreign firms were selling the good in the home market at FC 0 which converted into HC 0. With the exchange rate now at S(HC/FC) =., in order for them to get FC 0 for each sale they must price at HC. This is also the home market price in order to keep local firms from switching to exporting. Thus, local firms acting as the import competitors can also raise their price to, and their values rise accordingly to V =0, which also translates into a real increase in firm value. This is the short run story, the 0% depreciation of the HC leads to an 00% increase in the value of home country firms that either export of sell locally against foreign competitors. However, the current outcome is not an equilibrium. In the long run, the higher return to capital in this industry in the home country will draw in additional resources, bidding up the price of inputs (labor and raw materials) until the return on capital falls to its required level. This will be the case FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p. 4

5 when the costs of inputs and labor are driven up by 0% to HC 9.9. This price pressure leads to a one-time bout of inflation that will ultimately result in an aggregate price level increase of 0%, and a home country price index of P =.0. When this happens, the home country firm s cash flows will fall from to. (HC - HC 9.9) and firm value will fall to V =, with the real value of the firm returning to V /P = /.0= 0. Although firms value is nominally higher than originally at as compared to 0, this is just adjusting for the 0% higher prices in the home country. The real value of the firm to investors is the same as before. Many will notice that the price increase necessary to restore equilibrium is the same necessary to re-establish PPP. The 0% depreciation of the home currency need to be offset by a 0% increase in home currency prices to return the real value of the home currency to the initial level. In other words, the real exchange rate change, (at time ) resulted in higher value of home country firms as they temporarily had a competitive advantage over foreign firms, but when the real exchange rate returned to its equilibrium level, (time ) such competitive advantage and increase in (real) firm value disappeared. This dynamic is important to understand because it makes it clear why it is only changes in the real exchange rate that matter. Thus it should be clear that operating exposure only arises from real exchange-rate changes. One can also use this example to show that if there were no price frictions in the world, (i.e., the law of one price held for all goods at all times) this exposure would never arise. In such world, the depreciation of the HC would be matched instantaneously by an offsetting rise in all home country prices. The results would be no real change as there had never been a real exchange rate changes and every thing would operate as before with a higher home country price level and a depreciated HC. One can work through the dynamics of a 0% real appreciation of the HC and see that in the short run the profits of the firms with domestic production fall to zero, and return to equilibrium (that level necessary to make the real value of the firm to 0) only when wages in that sector fall to reduce operating costs sufficiently. One last important point to note that many people often overlook with respect to operating exposure is that the import competitive firms in this example, from outward appearance, have no direct link to the international markets. They produce their goods with locally priced inputs and sell them in the local market for home currency. None of their cash flows are denominated in FC; however, these firms still have an operating exposure to exchange rate changes, just as the exporting firms: their value changes as a result of changes in the real exchange rate. This is because these firms compete against foreign firms with costs based in FC. Therefore, simplistic claims that one is not exposed to exchange rates because they have no FC transactions, assets or liabilities, while it is true for translation and transaction exposure, is not true for operating exposure. Case of the Importer While it is tempting to think that the results for a firm involved in importing activities are the opposite of an exporting firm, this is not always the case. As we will see, it depends crucially on the nature of the market and the currency in which input prices are determined. For example, suppose that instead of producing in the home market, a firm owned by home country residents in the above example had its production facilities located in the foreign country (we would call this firm a multinational). The firm either provides the foreign market (we will consider the case of foreign operations later) or it may ship the goods back into the home market thus acting as an importer. The key point is that is that the owners of this firm value their profits in HC. Consider the case of the firm acting as an importer. Originally, as above, the exchange rate is S(HC/FC) = and firm value is V 0 = 0. Again, there is a 0% real depreciation of the HC, S(HC/FC) =. Just as before, the price of the good in the home market rises firm HC 0 to HC The importing firm has costs of FC 9 due to production in the foreign country Now the HC needed to cover these costs becomes HC 9.9 (FC 9 $. HC/FC). This results in a net cash flow for the importing firm of HC.. This is the long run equilibrium profit of the domestic firms above resulting from the 0% depreciation. So as a result of the depreciation, the value of the importing FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p. 5

6 firm rises only to V = in the short run. There is virtually no change in firm value in the short run (unlike the exporting firms). [In fact one may argue that there is a relative decrease in firm value relative to exporting and import competing firms in the same industry in the short run]. Eventually as the home country s general price level rises in response to the increased price pressures resulting from the devaluation, the increase in prices (0% in the long run) ends up leaving the same real cash flow in HC as before the depreciation for the importing firm. Firm value remains at V = but real firm value returns to V /P = 0. Thus, in the end everything is the same because the change in the real exchange rate has reverted to zero. Working through the case with a 0% appreciation yields the same result: virtually no change in profitability, and therefore no change in firm value for the importer. The reason for this much smaller impact of exchange rate changes on firm value for the importing firm is that these firms are naturally hedged so that its operating exposure is close to zero. Both its revenue stream and cost stream are economically denominated in foreign currency. Only its net cash flows (profits) are exposed to currency fluctuations. Since this is much smaller than its revenues, it has a smaller exposure. This demonstrates a fundamental point about operating exposure analysis: the determination of operating exposure is really an analysis of the economic currency denomination (as opposed to notational denomination) of the cash inflows and outflows of the firm. This example brings out an important point for long run exposure analysis; that unexpected real exchange-rate changes eventually have impacts on overall price levels that offset the original change (i.e. PPP holds in the long run). A depreciation of the home currency usually puts upward pressure on domestic prices as it raises the costs of goods with a FC price. There is substantial evidence for this. Inflation in most of the SE Asian countries has increased sharply as a result of those currencies devaluations. This is a result of two things: one the depreciation now makes all imported products more expensive immediately, and two, the devaluation also generally stimulates economic activity (export boom) causing other prices to rise. Oppositely, an appreciation of the domestic currency tends to have a mitigating influence on prices as it makes foreign goods less expensive and depresses domestic activity. This will cause pricecutting by domestic agents resulting in slower inflation or possibly even deflation. In all the cases above price eventually adjust to restore initial real equilibrium, just at different nominal prices. Operating Exposure with Imperfect Competition and Strategic Behavior Despite what economists would like to think, the world is generally not characterized by perfect competition. Most firms that participate in international activities are large, and tend to have some market power. They also have the ability to partially segment the markets that they serve. However, they do face competition from other international firms that limits their market power. In a world with imperfect competition, the possibilities also arise for strategic behavior, in the sense that a firm attempts to gain advantages over its competitors even at some short run cost to itself, presumably because of expected gains from increasing market share (economies of scale) or market power (driving competitors out of business). We will consider strategic behavior in terms of pricing policy: a firm has market power to choose between market determined trade-off of price and quantity. As such behavior is more descriptive of the real world, below we consider several examples to demonstrate how operating exposure can vary depending on the activities and strategic behavior of firms. First, we will examine firms with domestic operations only. Before we begin, we need to discuss the metric for the strategic pricing behavior. The important question is how the firm alters the foreign currency price of its good in response to an exchange-rate change. This is known as the passthrough effect. Passthrough is the ratio of the percentage change in the foreign currency price of your exports to the Passthrough FC price of export = % FC % S( ) HC percentage change in the foreign currency price of domestic currency. FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p. 6

7 While passthrough can theoretically take on any value, it is usually in the range between zero and one. These two points represent specific behaviors with respect to FC price changes and exchange-rate changes. When passthrough is zero, this means that the firm absorbs the gain or loss on the HC value of the product resulting from an exchange-rate change as they do not alter the FC price of the good. Thus, when the HC appreciates and passthrough is zero, the firm keeps the FC price of the good fixed and accepts the proportionally smaller HC proceeds of a foreign sale. Similarly, when the HC depreciates and passthrough is zero, the firm keeps the FC price of the good fixed and captures the proportionally larger HC proceeds of each foreign sale. When passthrough is one, the firm has passed through the impact of the exchange-rate change into the FC price of the good to the foreign consumers. Thus when the HC appreciates, the firm raises the FC price of the good by the same proportion as the exchange-rate change, leaving the HC proceeds of a foreign sale the same as before the exchange-rate change. Similarly, when the HC depreciates, the firm lowers the FC price of the good and receives the same HC proceeds of each foreign sale as before the exchange-rate change. Thus with passthrough equal to one, the firm s FC price (and therefore quantity) fluctuates and the HC revenue per foreign sale remains fixed. When passthrough is zero, the firm has eaten the impact of the exchange-rate change as it does not pass them through into the FC price of the good to the foreign consumers. Regardless of the exchange rate change the firm keeps the FC price of the good fixed, and allows its HC revenues per sale to fluctuate. Thus when the HC appreciates, the firm keeps the FC price of the good fixed, resulting in a decrease in the HC proceeds of a foreign sale. When the HC depreciates, the firm also keeps the FC price of the good fixed and receives the larger HC proceeds of each foreign sale. Thus with passthrough equal to zero, the firm s FC price (and therefore quantity) remain fixed and the HC revenue per foreign sale remains fluctuates. Notice that in either case total HC proceeds from the foreign market fluctuate with the exchange rate. Be aware that price fluctuations in the foreign market will result in quantity fluctuations (as long as demand in not perfectly inelastic). Thus, another way to think about passthrough is that choosing passthrough of zero attempts to maintain quantity stability at the expense of HC profit margin stability. Choosing passthrough of one attempts to maintain HC profit margin stability at the expense of quantity variability. Alternatively, choosing passthrough of zero attempts to maintain quantity stability at the expense of HC profit stability. In strategic terms, setting passthrough at zero when the HC appreciates and at one when the HC depreciates is an aggressive pricing behavior (one that seeks to maintain or maximize market share). This is also known as pricing to market. A policy of maintaining passthrough at one all the time (making the foreign-currency price reflect all the variability in exchange rates) corresponds to the maintenance of a fixed HC margin on each good. This was a common policy of U.S. firms prior to the mid 980s. In reality, passthrough can vary anywhere between zero and one, depending on market structure, elasticity of demand, the behavior of competitors and strategic considerations. In a world where firms have some market power, the determination of passthrough is a corporate decisions that must be made in response to market conditions. As we shall see below, passthrough decisions do not affect the relative performance of the firms in strategic interaction as a result of exchange rate changes but they will have an influence on the reported impact of exchange-rate changes on the reported operating performance. Examples of Operating Exposure with Imperfect Competition Domestic Production Only Let us consider a situation where there are two representative firms, one in the U.S. and the other in Germany. These firms operate in an oligopolistic industry and each possesses some degree of market power. Each firm produces a similar good that are close substitutes with the other and sells it in both countries. There are no transport costs and the products initially have the same price. Initially all inputs to production are available in segmented domestic markets. Assume that market conditions have led the products to have originally had the same price and unit profitability and the two firms split each market. FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p. 7

8 Initially the exchange rate is S(DM/$) =.00. The condition of each firm is: U.S. Germany Cost of production $5 DM0 Price in home market $0 DM0 Price of exports $0 = DM0 DM0 = $0 Initially the profit margin is $5 in the U.S. and DM0 in Germany. If we assume that each firm sells the same quantity initially, then the expected value of each firms cash flows are the same at the current spot exchange rate. Suppose the nominal exchange-rate changes unexpectedly resulting in a real exchange-rate change. The new spot rate is S(DM/$) =.00 ($ depreciation of 50%) and there has been no change in input prices. The real dollar depreciation provides a competitive advantage to the slack to the U.S. exporter. The new situation in the market depends on the pricing behavior of the firms. The U.S. producer may set passthrough to one by lower her export price to DM0 and squeeze her German competitor, forcing her to lower her price to DM 0 or to lose market share. Alternatively, assuming that she has the ability to segment her markets, the U.S. exporter can be passive and keep her export price at DM 0 and enjoy larger profit margins on the same quantities as before. The price in the U.S. market will, in a similar fashion, depend on the reaction of the German firm to the exchange rate change. If the German producer reacts passively, (passthrough = ) then the price of German imports in the US rises to $0 $/DM), leaving the US producer room either to raise her domestic price and/or increase her share of sales in the US market. The possible results resulting form the dollar depreciation look like: U.S. Firm German firm Passive Behavior PT = Aggressive Behavior PT = 0 Passive Behavior PT = 0 Costs P HM P X U.S. Germany $5 DM0 $0 DM0 $0 = DM0 DM0 = $0 U.S. Germany $5 DM0 $0 DM0 $0 = DM0 DM0 = $0 Aggressive Behavior PT = Costs P HM P X U.S. Germany $5 DM0 $0 DM0 $0 = DM0 DM0 = $0 3 In addition to these four polar cases, there are an infinite set of possible results in between. U.S. Germany $5 DM0 $0 DM0 $0 = DM0 DM0 = $0 4 In all four cases, the U.S. producer has gained relative to the German producer. In square, both the U.S. and German producer react passively to the exchange rate change. The result is a price increase in the U.S. by both producers. However, this price increase only leads to higher profit margins for the U.S. firm [note that there will be a decrease in the quantity demanded as a result of the price increase, but this will be shared by both firms]. Unless the decrease in quantity demanded is substantial, the U.S. firm should benefit because in has tripled its profit margin on domestic sales while the German firms profit margin on exports remains unchanged (because of the change in the exchange rate). In the German market, since the U.S. firm reacted passively, the price remains at DM0. Thus the German firm see no change in its cash flows from the domestic market; however, the U.S., firm, by selling at DM0 now receives $0 for each sale, resulting in much higher dollar cash flows from the German market. So the German firm experiences only a partial decrease in total cash flows (due to the decreased sales in the U.S.) resulting from the price rise, while the U.S. firm experiences an increase in cash flows, from exports, and perhaps, also from domestic sales FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p. 8

9 (depending on demand elasticity). Thus the U.S. firm has improved its competitive position vis-a-vis its German competitor. In square 4, the same relative result holds, except it takes a dramatically different form. As both firms have priced aggressively, the consumer is the big winner. The price in the U.S. market remains at $0 and the price in the German market is driven to DM0 by the aggressive U.S. pricing. As a result the German firm is severely squeezed. It earns no profits on its export sales in the U.S. as the $0 just covers the DM0 costs. It also makes no profits in the German market with the price driven down to DM0. On the other hand, the U.S. firm s cash flows increase but only slightly. In the U.S. market nothing has changed for the U.S. firm: it still sells the same quantity at $0 per sale. In the German market, by pricing at DM0 the U.S. firm will experience an increase in export sales [as will the German firm experience an increase in domestic sales due to the price reduction], and the dollar profit margin on each export sale is the same as it was prior to the exchange rate change. Thus in square 4, the U.S. firm experiences a small increase in cash flows from the export market while the German firm is severely squeezed, experiencing a dramatic decrease in cash flows and perhaps facing financial distress. It is important to note that the off-diagonal entries (squares and 3) require the ability to segment markets as the price of the good is significantly different in one country than the other. Unless market segmentation exists, arbitrageurs will purchase the item in the low cost area and ship them to the high cost location and arbitrage away the price difference. In the absence of this ability, the results will lie somewhere in between with the prices possibly converging around some level like $5 and DM5. In any case, it can be seen by examining these situations that the U.S. firm experiences a relative increase in its cash flows compared to the German firm. The bottom line is that a depreciation of the domestic currency benefit the competitive position (cash flows and thus value) of domestic firms involved in exporting or import competing activity. This benefit continues until the real exchange rate returns to its original level. U.S. Firm with Imported Inputs to Production: Suppose that the U.S. firm changed the sourcing of its inputs to make use of some inputs that are sold in Canada. In addition let us assume that the U.S. firm does not export, but does face competition from the German exports. The imported inputs used by the U.S. firm come from Canada and their price is determined in the Canadian market in Canadian dollars. Let us assume that initially S(C$/$) =.00. Together with all of the original assumption from above, we have the following situation with the German competitor (assume it does not use imported inputs): U.S. Germany Cost of local input $ DM0 Cost of imported input C$3 = $3 - Total Cost $5 DM0 Price in U.S. market $0 DM0 = $0 The initial profit margins are $5 per unit for the U.S. local market sales and DM0 per unit on each German export to the U.S. Now suppose that there is a real change in the value of the Canadian dollar, so that S(C$/$) =.5 (dollar appreciation against the Canadian dollar), while prices in Canada remain the same [the price of the input the U.S. firm imports from Canada remains at C$3]. If the exchange-rate change is due to Canadian factors so that S(DM/$) remains unchanged at DM.00/$ the following are the polar cases assuming fixed Canadian prices: FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p. 9

10 U.S. firm Aggressive Pricing Behavior Passive Pricing Behavior local input costs imp input costs Total costs P US U.S. Germany $ DM0 C$3=$ - $4 DM0 $9 DM8=$9 U.S. Germany $ DM0 C$3=$ - $4 DM0 $0 DM0=$0 Although these represent just two of many possible market outcomes as a result of these events, it draws out two important points. First, as an importer of inputs that are sold in a competitive foreign market, the U.S. firm gains a competitive advantage as a result of the appreciation of its home currency against that foreign currency (the Canadian dollar) vis-a-vis the German competitor. The C$/$ exchange-rate change reduces the dollar costs of its imported inputs and thereby reduces its costs of production. In square, we assume the U.S. firm takes an aggressive pricing behavior and lowers its final output price by the full amount of the imported input price reduction. [Note while this is analogous to PT =, it is not exactly the same as our definition as the firm is changing a domestic currency price]. The result of the domestic price reduction is that it forces the German firm to react, either by lower its export price or surrendering market share. The net result is more domestic sales, as a result of the lower price, and the same profit margin per sale, leading to greater cash flows for the U.S. firm, and a decrease in export cash flows for the German firm. In square, a similar result will hold, but as with the previous table, it will take a slightly different form. In this situation, we assume that the U.S. firm takes a passive pricing stance (the analogous position to PT = 0) and keeps the benefits of the reduced input costs into a higher profit margin. Thus the price in the U.S. market does not change, so quantity demanded does not change, but the U.S. firm now makes a profit margin of $6 on each sale whereas it made only $5 before. This leads to greater cash flows for the U.S. firm. The German firm on the other hand, sees no change in the market. The prices is still $0, which converts into receipts of DM0 on each export sale, and as quantity demanded does not change its cash flows from exporting do not change. However, it is now facing a stronger competitor on the U.S. market, and this may lead to some second-order valuation effects that could slightly reduce the value of the German firm. However, the relative result is the same, a relative increase in cash flows and value for the U.S. firm. This example demonstrates the simple intuition regarding the operating exposure of importing firms: firms that import goods with fixed foreign currency prices gain from a real appreciation of their home currency. Note that this is different from the exposure of an importing firm in a perfectly competitive environment. A similar situation would hold in our example above is the Canadian firm exporting the good the U.S. producer, increased his C$ price (kept the $ cost the same) in response to the exchange rate change (i.e. set his passthrough = 0). However, everything else held constant, importing creates a positive relation between the change in expected cash flows and the change in the real value of the home currency. The second point to note from this example is that the result of the Canadian dollar s real appreciation against the U.S. dollar also implies a real appreciation of the Canadian dollar against the DM. From triangular arbitrage, S(DM/C$) was originally.00 and has now become S(DM/C$) =.33. Although the German firm does not interact in the Canadian market, its cash flows can be affected by the real depreciation of the Canadian dollar. In square, due to the decrease in the U.S. market price, the German firm must lower its export price or lose sales. Thus, the current and expected future cash flows of the German firm from exporting to the U.S. market will have fallen, and with it, firm value. This demonstrates the point that you need not transact in a currency in order to have an operating exposure to it. If your competitors costs are exposed to a particular foreign currency, then you also will have some exposure to that foreign currency. FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p. 0

11 WARNING: Note on Real Exchange Rate Exposures Even with No Exchange-Rate Change While changes in nominal exchange rates are the most common source of real exchange rate fluctuations resulting in a high correlation between nominal and real exchange-rate changes real exchange rates may also change due to relative price changes even when nominal exchange rates are constant. This is especially true in developing countries and Europe where there are attempts to maintain fixed nominal exchange rates. Real exchange rates changes of this sort also give rise to operating exposures that can affect firm cash flows and thus current market value; although since they occur due to price changes (rather than FX changes) they usually occur more slowly. As a demonstration of this phenomenon, let us take the U.S. firm from the previous example and consider the effect of a generalized price increase in Canada relative to the U.S. with no offsetting change in the value of the Canadian dollar. Originally the cost of the imported Canadian input was C$3 = US$3 resulting in a total cost per good for the U.S. firm of $5. Now assume prices in Canada rise by 33% relative to the U.S. (Canada has 33% higher inflation than the U.S.) while the exchange rate remains fixed at S(C$/$) =.0. The result of this events is a real appreciation of the Canadian dollar and the price of the Canadian input rising from C$3 to C$4 leading to production costs of the U.S. firm rising from $3 to $4. Thus the total cost per good for the U.S. firm rises to $6. This squeezes the cash flows of the U.S. firm in competition with the German firm in the U.S. market. The result is exactly analogous to a real appreciation of the Canadian dollar due to a nominal exchange rate movement with fixed input prices; however, this time the exchange rate stayed fixed and prices moved. This is also different from domestic inflation under which both input and output prices would have risen. This distinction is important to keep in mind when we discuss hedging operating exposure since this type of operating exposure to real exchange-rate changes cannot be hedged via nominal foreign currency contracts. Summary of Impact of Exchange-Rate Changes on Firm s Local Production Cash Flows Real Depreciation of the Home Currency : increases profitability of exporters through higher margins and/or increased sales decreases profitability of importers through lower margins and/or decreases sales increases profitability of import competitors through higher margins and/or sales Real Appreciation of the Home Currency: decreases profitability of exporters through lower margins and/or decreased sales increases profitability of importers through higher margins and/or increase sales decreases profitability of import competitors through lower margins and/or sales Operating Exposure and Foreign Operations Above we considered the operating exposures to different activities when production was carried out in the local market. For multinational firms, on the other hand, a substantial amount of production occurs in foreign markets, generally with foreign currency costs. This production may either be sold in the local market or exported to some other foreign market for which it is sold for another foreign currency or it may be sold back to the parent s domestic market. Under these scenarios, exposures can differ substantially in terms of the value of the operating flows back to the parent operating flow. Generally speaking there are two things going on when determining the exchange rate exposure of foreign operation cash flows from the parent s point of view: there is the exposure of the operating cash flows denominated in the foreign currency (analogous to what we examined above), and then there is a valuation (or conversion) effect resulting from measuring the net foreign currency cash flows in the parent s currency. The size and sign of these two effects determine the operating exposure to the parent foreign operations. Below we consider several examples to demonstrate the possible outcomes. These examples are simple as they ignore the impacts of transaction exposures to focus completely on operating exposure of foreign subsidiaries. FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p.

12 No Operating Exposure in Foreign Currency Consider the case of a stand alone German subsidiary of a U.S. parent. Let us assume that this firm produces in Germany with DM costs and sells its goods in the German market. The initial exchange rate is S(DM/$) =.00 and a provisional estimate of expected cash flows generated by the subsidiary for the coming period looks as follows: German Subsidiary of U.S. Parent Revenues DM 00 Cost of goods DM 80 Profit DM 0 At the current exchange rate the contribution of the foreign subsidiary to the parent s consolidated financial performance is $0 (DM0 / DM/$). Now suppose that the S(DM/$) exchange-rate changes to S(DM/$) = 3.00 (50% dollar appreciation) due to economic factors in the U.S. with no immediate change in prices in either country. Since the disturbance causing the exchange-rate change was common to all exchange rates with the dollar, cross rates of other currencies against the DM that may influence the firm remain the same. To a first approximation, the exchange-rate change has no impact on the DM cash flows generated by the German subsidiary: they remain at DM0. Although it has no impact on the DM cash flows of the German subsidiary, the exchange-rate change has a one-for-one change on the dollar value of these cash flows: they fall to $6.67 (DM0 / DM3/$). Thus the dollar appreciation reduces the dollar value of the expected future cash flows of the foreign subsidiary to the U.S. parent, via the conversion effect by the amount the dollar changed in value against the DM. Note that this exchange rate impact on subsidiary value is the same as the effect on a fixed DM payoff instrument such as a bank deposit or a government bond. This demonstrates that when the foreign currency cash flows are independent of the exchange-rate change, either because of a lack of exposure to that particular exchange-rate change or a complete lack of exposure to exchange-rate changes (i.e., barbershops), there is a negative relation between a change in the real value of the parent currency vis-a vis the subsidiary currency and the parent-currency value of the foreign subsidiary. Note, for simplicity we are ignoring an accounting adjustment that may occur because of translation or transaction hedging. However, as was argued above, it is difficult to conceive of a firm that does not have some exposure to exchange rates. Under more realistic assumptions, the impact of exchange rate changes on the parent currency value of foreign operations requires a more careful look. AS we shall see it depends on identifying the size and the sign of the operating exposure of the foreign subsidiary. Subsidiary with Operating Exposure on the Cost Side Consider a German subsidiary of a U.S. parent with cost exposure. For example, let us assume that the German firm is a concrete producer that imports certain inputs to the process from abroad, say France. Since the subsidiary is an importer, we know it has an operating exposure on the cost side. To keep the analysis simple, we shall continue to assume that this subsidiary only sells its good in the German market and has no operating exposure in its revenues. The initial exchange rates are S(DM/$) =.00 and S(DM/FF) = A provisional estimate of expected cash flows generated by the subsidiary in the near future looks as follows: German Subsidiary of U.S. Parent Revenues DM 00 Local input costs: DM 40 Imports : DM 40 Total Costs DM 80 Profit DM 0 = $0 from parent perspective FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p.

13 At the current DM/$ exchange rate, this subsidiary contributes $0 per period to the parents overall expected cash flows. Consider the exposure to the parent from this enterprise of a generalized real appreciation of the DM (real depreciation of dollar against DM). This appreciation of the DM changes the exchange rates to S(DM/$) =.00, and S(DM/FF) = Given the assumed market conditions, revenue exposure is second order and is ignored; however, there is a cost exposure due to the importation of some inputs to production that are priced in French francs. As a result of the exchange-rate change, the expectation of DM cash flows for the subsidiary become: German Subsidiary of U.S. Parent Revenues DM 00 Local input costs: DM 40 Imports : DM 0 Total Costs DM 60 Profit DM 40 = $40 Now the German subsidiary s expected DM cash flows rise to DM40 which convert into $40 from the parent s perspective. With the subsidiary s cost exposure, the exposure of the parent arising form the foreign subsidiary was negatively related to the change in the real value of the parent currency and larger than in the case when the subsidiary had no operating exposure. Here the operating exposure of the subsidiary and the valuation effect are both working in the same direction. The operating exposure is the change in expected DM cash flows from DM0 to DM40. The valuation effect is the result of every DM now being worth $ instead of $0.50. Operating Exposure on the Revenue Side The alternative polar situation arises when the foreign subsidiary has an operating exposure on the revenue side. Consider a German subsidiary with a revenue exposure. For example, assume that the German subsidiary is a manufacturing plant that competes with other European firms in selling its good in Germany and also the other European countries. As this subsidiary is an exporter, we know it has a revenue exposure. For simplicity, we shall assume that there is no cost exposure: all production costs are denominated and determined in DM. Let us consider the same original exchange rates as the previous example, S(DM.$) =.00 and S(DM/FF) = A provisional expectation of the DM cash flows to the German subsidiary are: German Subsidiary of U.S. Parent Local DM revenues: DM 70 Export rev FF 3FF/DM: DM 30 Total revenues DM 00 Total Costs DM 80 Profit DM 0 = $0 At the current DM-$ exchange rate, this subsidiary contributes $0 per period to the parents overall expected cash flows. As before, consider the exposure to the parent from this enterprise of a generalized real appreciation of the DM. This appreciation of the DM changes the exchange rates to S(DM/$) =.00, and S(DM/FF) = Given our assumptions, cost exposure should be considered second order and is ignored; however, there is a revenue exposure due FNCE 79 WEMBA: Corporate Exposure to Exchange Rates p. 3