New version page

f55 ER Ch09 Economic Exposure

This preview shows page 1-2-3-4-5-6 out of 17 pages.

View Full Document
View Full Document

End of preview. Want to read all 17 pages?

Upload your study docs or become a GradeBuddy member to access this document.

View Full Document
Unformatted text preview:

11/30/201019Chapter NineManagement of Economic ExposureChapter Objective:This chapter provides a way to measure economic exposure, discusses its determinants, and presents p, ,pmethods for managing and hedging economic exposure.9-0Chapter Outline How to Measure Economic Exposure Operating Exposure: Definition An Illustration of Operating Exposure Determinants of Operating Exposure Managing Operating Exposure9-111/30/20102Economic Exposure Changes in exchange rates can affect not only firms that are directly engaged in international trade but also purely domestic firms. If the domestic firm’s products compete with imported goods then their competitive position is affected by the strength or weakness of the localaffected by the strength or weakness of the local currency.9-2Economic Exposure Consider a U.S. bicycle manufacturer who sources, produces and sells only in the U.S. Since the firm’s product competes against imported bicycles it is subject to foreign exchange exposure.Their customers are comparing the cost andTheir customers are comparing the cost and features of the domestic bicycle against Japanese, British, and Italian bicycles.9-311/30/20103Economic Exposure Exchange rate risk as applied to the firm’s competitive position. Any anticipated changes in the exchange rates would have been already discounted and reflected in the firm’s value. Economic exposure can be defined as the extentEconomic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates.9-4How to Measure Economic Exposure Economic exposure is the sensitivity of the future hlfhfi’dhome currency value of the firm’s assets and liabilities and the firm’s operating cash flow to random changes in exchange rates. There exist statistical measurements of sensitivity. Sensitivity of the future home currency values of the fi ’ t d li biliti t d h ifirm’s assets and liabilities to random changes in exchange rates. Sensitivity of the firm’s operating cash flows to random changes in exchange rates.9-511/30/20104Asset exposureChannels of Economic ExposureHome currency pFirm Valueyvalue of assets and liabilitiesExchange rate fluctuationsOperating exposureFuture operating cash flowsfluctuations9-6How to Measure Economic Exposure If a U.S. MNC were to run a regression on the dll l (P)fiBiih hdlldollar value (P) of its British assets on the dollar pound exchange rate, S, the regression would be of the form:P = a + b×S + eWherea is the regression constante is the random error term with mean zero. The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S. 9-711/30/20105How to Measure Economic ExposureThe exposure coefficient, b, is defined as follows:Cov(P, S)Var(S)b = Where Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate, and Var(S) is the variance of the exchange rate.9-8How to Measure Economic Exposure The exposure coefficient shows that there are two sources of economic exposure:1. The variance of the exchange rate and 2. The covariance between the dollar value of the asset and exchange rateCov(P, S)Var(S)b = 9-911/30/20106Example Suppose a U.S. firm has an asset in France whose local currency price (P*) is random. S is the future spot rate For simplicity, suppose there are only three states of the world producing some combination of P* and S. Each state is equally likely to occur.The dollar value of the asset (P) which is aThe dollar value of the asset (P), which is a product of P* and S, will be determined, depending on the realized state of the world.9-10Example (continued)State Probability P* S S×P*Case 1: P* & S are positively correlated - (high operating exposure)1 1/3 €980 $1.40 $1,3722 1/3 €1,000 $1.50 $1,5003 1/3 €1,070 $1.60 $1,712Case 2: P* & S are negatively correlated - (minimal operating exposure)1 1/3 €1,000 $1.40 $1,4002 1/3 €933 $1.50 $1,4003 1/3 €875 $1.60 $1,400Case 3: P* & S are uncorrelated - (operating exposure reduced to transaction exposure)1 1/3 €1,000 $1.40 $1,4002 1/3 €1,000 $1.50 $1,5003 1/3 €1,000 $1.60 $1,6009-1111/30/20107Computation of Beta: Case 1-39-12Case 1: Computation of Beta1. Computation of MeansP = 1/3× (€1,372 + €1,500 + €1,712) = €1,528S = 1/3× ($1.40/€ + $1.50/€ + $1.60/€) = $1.50/€2 Computation of Variance and Covariance2. Computation of Variance and CovarianceVar(S) = 1/3× [($1.40/€ – $1.50/€)2+ ($1.50/€ – $1.50/€)2+ ($1.60/€ – $1.50/€)2] = 0.02/3Cov(PiS) = 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/€)] = 34/33. Computation of the Exposure Coefficient3. Computation of the Exposure Coefficient= Cov(P,S)/Var(S) = (34/3)/(0.02/3) = €1,700State Probability P* S S×P*1 1/3 €980 $1.40 $1,3722 1/3 €1,000 $1.50 $1,5003 1/3 €1,070 $1.60 $1,7129-1311/30/20108Hedging Strategy Based on our estimate: P = a + b×S + e b = the optimal hedge ratioIn this case the proceeds from the hedge:b(FS)In this case, the proceeds from the hedge: b (F –S) Var (P), the variance of the dollar value of the asset can be decomposed as: Var (P) = b2Var (S) + Var (e) b2Var (S) = Variability that can be hedged (Systematic risk). Var (e) = residual variance, that cannot be hedged (unsystematic risk)9-14Summary of Hedging ParametersCase b Var (P) b2Var (S) Var (e)C1O i I fhdCase 1 1,700 19,556 19,174 392Case 2 00 0 0Case 3 1,000 6,667 6,667 0Case 1: Operating exposure. Imperfect hedge.Case 2: No operating exposure. No need to hedgeCase 3: Transaction exposure. Use transaction hedge 9-1511/30/20109Financial Hedging Example: Case 1At T = 0, if we sell €1,700 forward at the 1-year forward rate, F1, that prevails at time zero. Suppose that F1= $1.50T = 0 T = 1€980P*S1$1.40× = $1,372F1Sell €1,700×$1.50=$2,550Buy €720 at $1.40 =$1,008net cash flow =$1,542€1,000€1,070$1.50$1.60××==$1,500$1,712Sell €1,700×$1.50=$2,550Buy €700 at $1.50 =$1,050net cash flow =$1,500Sell €1,700×$1.50=$2,550Buy €630 at $1.60 =$1,008net cash flow =$1,5429-16Financial Hedging Example: Case 2At T = 0, if we sell  = 0 forward at the 1-year forward rate that prevails at time zero(Suppose that F1($/€) = $1.50)T = 0 T = 1€1,000P*S1$1.40× =


Loading Unlocking...
Login

Join to view f55 ER Ch09 Economic Exposure and access 3M+ class-specific study document.

or
We will never post anything without your permission.
Don't have an account?
Sign Up

Join to view f55 ER Ch09 Economic Exposure and access 3M+ class-specific study document.

or

By creating an account you agree to our Privacy Policy and Terms Of Use

Already a member?