Chapter 10

Managing Economic
Exposure

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
© Cengage Learning EMEA 2014
 Economic exposure
• Economic exposure refers to the degree to which a firm’s
present value of future cash flows can be influenced
by exchange rate fluctuations.

• Some of these affected cash flows do not require

currency conversion.

• Even a purely domestic firm may be affected by

economic exposure if it faces foreign competition in its
local markets.
 Economic exposure
• In technical terms, economic exposure is the extent
to which the value of the firm—as measured by the
present value of its expected cash flows—will change
when exchange rates change.

• Recall that exchange rates will affect directly actual

currency conversions (transaction exposure) and
indirectly through its effect on competition and other
factors
 Economic exposure
• From a U.S. firm’s perspective, transaction exposure
represents only the exchange rate risk when converting
net foreign cash inflows to U.S. dollars or when
purchasing foreign currencies to send payments.

• Economic exposure represents any impact of

exchange rate fluctuations on a firm’s future cash
flows. Corporate cash flows can be affected by
exchange rate movements in ways not directly
associated with foreign transactions.
 Economic Exposure (2)
The economic impact of currency exchange
rates on us is complex because such changes
are often linked to variability in real growth,
inflation, interest rates, governmental actions,
and other factors. These changes, if material,
can cause us to adjust our financing and
operating strategies.
PepsiCo

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
© Cengage Learning EMEA 2014
 Example
• Nike’s economic exposure comes in various forms.

• First, it is subject to transaction exposure because of

its numerous purchase and sale transactions in foreign
currencies, and this transaction exposure is a subset of
economic exposure.
• Second, any remitted earnings from foreign subsidiaries
to the U.S. parent also reflect transaction exposure and
therefore reflect economic exposure.
 Example
• Third, a change in exchange rates that affects the
demand for shoes at other athletic shoe companies
(such as Adidas) can indirectly affect the demand for
Nike’s athletic shoes.
• Nike attempts to hedge some of its transaction exposure,
but it cannot eliminate it because it cannot predict all
future transactions.
 Example
• Moreover, even if it could eliminate its transaction
exposure, it cannot perfectly hedge its remaining
economic exposure;
• It is difficult to determine exactly how a specific
exchange rate movement will affect the demand for a
competitor’s athletic shoes and, therefore, how it will
indirectly affect the demand for Nike’s shoes.
 Example 2
• At the current time Sports Exports Company (US) is
willing to receive payments in British pounds for the
monthly exports it sends to the UK.
• While all its receivables are denominated in
pounds, it has no payables in pounds or any other
foreign currency.
• Jim Logan, the owner, wants to assess his firm’s
exposures to exchange rates risk.
Use of the Income Statement to
Assess Economic Exposure
• An MNC can determine its exposure by assessing the
sensitivity of its cash inflows and outflows to various
possible exchange rate scenarios.
• For a single currency
DCFt = a0 + a1et + t

DCFt= %  in Discounted cash flows

measured in the firm’s home currency over
period t
et = %  in the exchange rate over period t

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
© Cengage Learning EMEA 2014
Use of the Income Statement to
Assess Economic Exposure
Assessment of Each Unit’s Exposure:
%DCFt = a0 + a1%et + t

Unit Slope Coefficient R-squared

Statistic
A Not significant 6.8%
B Not significant 6.7%
C Statistically significant 93%
 Unit C is exposed to the euro’s movements.

The MNC can then reduce its exposure by restructuring

its operations to balance its exchange-rate-sensitive cash
flows.
 How Restructuring Can
Reduce Economic Exposure
• Restructuring to reduce economic exposure
involves shifting the sources of costs or revenue to
other locations in order to match cash inflows
and outflows in foreign currencies.

• The proposed structure is then evaluated by

assessing the sensitivity of its cash inflows and
outflows to various possible exchange rate
scenarios.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
© Cengage Learning EMEA 2014
 Example from ch 10 –
Mannerton plc
• Mannerton plc sells to the UK and Europe

– A strong € increases UK sales somewhat due to

increased competitiveness

– European sales are assumed to be constant at €40

and European costs are much higher (about € 200)

• Mannerton therefore lose money if the € appreciates

Impact of exchange rate movements
Scenario 1 Scenario 2 Scenario 3
Euro exc. rate 0,6 0,7 0,8
UK sales (£) 300,00 304,00 307,00
European sales (€ 40) 24,00 28,00 32,00
Total sales 324,00 332,00 339,00

Cost of goods sold:

UK costs 50,00 50,62 51,08
European Costs 120,00 141,73 163,46
Total costs 170,00 192,35 214,54

Gross profit 154,00 139,65 124,46

Operating expenses:
UK fixed costs 30,00 30,00 30,00
UK variable costs 30,72 31,10 31,38
Total 60,72 61,10 61,38

EBIT 93,28 78,56 63,08

Interest expense:
UK interest 3,00 3,00 3,00
European interest (10 m €) 6,00 7,00 8,00
Total 9,00 10,00 11,00

Earnings before taxes (EBT) 84,28 68,56 52,08

 Mannerton plc
• Mannerton should change its operational
structure by increasing European sales and
decreasing the share of European costs
– Increase € sales
– Reduce € costs and increasing £ costs
– Increase £-borrowing and reduce €-borrowing
Different operational structure
Scenario 1 (0.6) Scenario 2 (0.7) Scenario 3 (0.8)
Original Proposed Original Proposed Original Proposed
Euro exc. rate 0.6 0.6 0.7 0.7 0.8 0.8
UK sales (£) 300.00 300.00 304.00 304.00 307.00 307.00
European sales (€ 40) 24.00 36.00 28.00 42.00 32.00 48.00
Total sales 324.00 336.00 332.00 346.00 339.00 355.00

Cost of goods sold:

UK costs 50.00 130.00 50.62 131.55 51.08 132.71
European Costs 120.00 60.00 141.73 70.83 163.46 81.67
Total costs 170.00 190.00 192.35 202.38 214.54 214.38

Gross profit 154.00 146.00 139.65 143.62 124.46 140.62

Operating expenses:
UK fixed costs 30.00 32.00 30.00 32.00 30.00 32.00
UK variable costs 30.72 31.72 31.10 32.10 31.38 32.38
Total 60.72 63.72 61.10 64.10 61.38 64.38

EBIT 93.28 82.28 78.56 79.52 63.08 76.24

Interest expense:
UK interest 3.00 6.50 3.00 6.50 3.00 6.50
European interest (10 m €) 6.00 3.00 7.00 3.50 8.00 4.00
Total 9.00 9.50 10.00 10.00 11.00 10.50

Earnings before taxes (EBT) 84.28 72.78 68.56 69.52 52.08 65.74
 Earnings before tax £
90

80
million 70

60

50
1 2 3
Scenarios
Exchange rate scenarios
the original steep slope is replaced through
reducing exposure by the dotted lesser slope. It
is less risky, fewer losses but fewer gains from
exchange rate variation

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
© Cengage Learning EMEA 2014
 Issues Involved in the
Restructuring Decision (1)
• Restructuring operations is a long-term solution to
reducing economic exposure.

It is a much more complex task than hedging any foreign

currency transaction.

• MNCs must be very confident about the long-term

potential benefits before they proceed to restructure their
operations, because of the high reversal costs.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
© Cengage Learning EMEA 2014
 Issues Involved in the
Restructuring Decision (2)
• Restructuring may involve:
1. Increasing/reducing sales in new or existing
foreign markets
2. Increasing/reducing dependency on foreign
suppliers
3. Establishing/eliminating production facilities in
foreign markets, and/or
4. Increasing/reducing the level of debt
denominated in foreign currencies.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
© Cengage Learning EMEA 2014
 Hedging Exposure to Fixed Assets and
other non regular transactions

• When an MNC has fixed assets (such as buildings

or machinery) in a foreign country, the cash flows
to be received from the sale of these assets is
subject to exchange rate risk.

• A sale of fixed assets can be hedged by creating a

liability that matches the expected value of the
assets at the point in the future when they will be
sold.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
© Cengage Learning EMEA 2014
 Example
• Wagner Co pursued a 6-year project in Russia. It purchased a
manufacturing plant from Russian government six years ago
for 500mill rubles ($80mill).

• Russian gov. guaranteed to repurchase the plant for 500mill

rubles in six years.

• The ruble dropped from $0.16 to $0.034

• 500mill rubles = $17mill

• What could Wagner Co have done?

 Example
• Sell currency forward in a long term contract. However, no-
existing for some emerging markets

• Wagner Co could have financed the project by borrowing

rubles from local bank.

• Structuring the loan with zero interest payments and a lump-

sum repayment value equal to the sale price of the asset.
500mill rubles (the guaranteed payment of the government)