Management ofEconomic ExposureChapter Seven
ChapterObjectives:This chapter provides a way to measureeconomicexposure, discusses itsdeterminants, and presents methods formanaging and hedging economicexposure
❖Chapter Objectives: ❖This chapter provides a way to measure economic exposure, discusses its determinants, and presents methods for managing and hedging economic exposure
ChapterOutlineHow to Measure Economic ExposureDeterminants of Operating ExposureManagingOperating Exposure
Chapter Outline ❖How to Measure Economic Exposure ❖Determinants of Operating Exposure ❖Managing Operating Exposure
WhatisEconomicExposure?Economic Exposure can be defined asthe extent to which the value of the firmwould be affected by unanticipatedchanges inexchangerates
What is Economic Exposure? Economic Exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates
ChannelsofEconomicExposureChanges inexchangeratescanhaveaneffect on firm's assets and liabilities and thuson its value. (asset exposure)Changes in exchange rates can have aprofound effect on firm's competitive positionin the world market and thus on its cash flowsand market value. (Operating exposure)
Channels of Economic Exposure ❖Changes in exchange rates can have an effect on firm’s assets and liabilities and thus on its value. (asset exposure) ❖Changes in exchange rates can have a profound effect on firm’s competitive position in the world market and thus on its cash flows and market value. (Operating exposure)
asset exposureHome currencyvalueofassetsand liabilitiesExchangeratefluctuationsFirm valueoperatinglexposureFutureoperatingcashflowsChannelsofEconomicExposure
Channels of Economic Exposure Home currency value of assets and liabilities Future operating cash flows Exchange rate fluctuations Firm value
MeasurementsofEconomicExposureTo determine the magnitude ofexposureExposure to currency risk can bemeasured by the sensitivities of :(1) the future home currency values of thefirm's assets (and liabilities )(2) the firm's operating cash flows to randomchanges in exchange rates
Measurements of Economic Exposure ❖To determine the magnitude of exposure ❖Exposure to currency risk can be measured by the sensitivities of : (1) the future home currency values of the firm’s assets (and liabilities ) (2) the firm’s operating cash flows to random changes in exchange rates
HowtoMeasureAssetExposureThere exist statistical measurements of sensitivity If a U.S. MNC has an asset in U.K., its exposure tocurrencyrisk can be measured by the coefficient inregressing on the dollar value (P) of its British assetson the dollar pound exchange rate, S($/), theregression would be of the form:P=a+bxS+e.Where a is the regression constant and e is the randomerror term with mean zero. The regression coefficient bmeasures the sensitivity of the dollar value of the assets(P) to the exchange rate, S
How to Measure Asset Exposure ❖ There exist statistical measurements of sensitivity ❖ If a U.S. MNC has an asset in U.K., its exposure to currency risk can be measured by the coefficient in regressing on the dollar value (P) of its British assets on the dollar pound exchange rate, S($/£), the regression would be of the form: P = a+bS +e •Where a is the regression constant and e 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
HowtoMeasureAssetExposureThe exposure coefficient, b, is defined asfollows:Cov(P, S)b =Var(S)Where Cov(P,S) is the covariance betweenthe dollar value of the asset and the exchangerate, and Var(S) is the variance of theexchange rate
How to Measure Asset Exposure The exposure coefficient, b, is defined as follows: Var( ) Cov( , ) S P 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
Howto MeasureAssetExposureCov(P, S)b:Var(S)The exposure coefficient shows thatthere are two sources of economicexposure: the variance of the exchangerate and the covariance between thedollarvalue ofthe asset andexchangerate
How to Measure Asset Exposure • The exposure coefficient shows that there are two sources of economic exposure: the variance of the exchange rate and the covariance between the dollar value of the asset and exchange rate. Var( ) Cov( , ) S P S b =