Hedging Economic Exposure

Transaction Exposure vs. Economic Exposure Profits = e (Price – Unit Costs) Q Transaction exposure refers to changes in the $ value of costs/revenues due to exchange rate movements Economic exposure refers to changes in the $ value of costs/revenues due to changes in demand (caused by exchange rate movements)

Example: Exporting to Britain Suppose that GM is exporting automobiles to England. Revenues = e*P* Sales Exchange Rate ($/L) Price (L) If price, and sales are constant (i.e. independent of the exchange rate) then GM only faces transaction exposure. However, if price and sales are influenced by the exchange rate, the GM faces economic exposure as well.

“ The economic impact of currency exchange rates on us is complex because such things are often linked to real growth, inflation, interest rates, governmental actions” Revenues = e*P* Sales Cash flows might be functions of a lot of things that are associated with exchange rate changes!!

Example: Suppose that Pepsi has subsidiaries in both the US and Canada. Below is Pepsi’s income statement. Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable Total EBIT $300 C$4 *.75 = $3 $303 $50 C$200 *.75 = $150 $200 $30 $60 $43 Canadian sales and costs are unaffected by exchange rate movements, but are subject to transaction exposure US costs are independent of the Exchange rate, but US sales rise when the Canadian dollar strengthens (Canadian goods become more expensive)

If the Canadian Dollar Strengthens, both Costs and Sales are Affected. Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable Total EBIT $300 C$4 *.75 = $3 $303 $50 C$200 *.75 = $150 $200 $30 $60 $43 Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable $310 C$4 *. 80 = $3.20 $ $55 C$200 *. 80 = $160 $215 $30 $33 1 CD = $.75 1 CD = $.80 EBIT$35.20 $63

What can Pepsi do to Lower its currency exposure Pepsi could attempt to better manage its cash flows

Example: Suppose that Pepsi has subsidiaries in both the US and Canada. Below is Pepsi’s income statement. Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable Total EBIT $300 C$4 *.75 = $3 $303 $50 C$200 *.75 = $150 $200 $30 $60 $43 If Pepsi could raise its Canadian Sales and lower its Canadian costs, it would be better insulated from exchange rate changes

Increasing Canadian sales and lowering Canadian costs lowers exposure Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable Total EBIT $300 C$20 *.75 = $15 $315 $140 C$100 *.75 = $75 $215 $30 $60 $40 Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable $310 C$20 *. 80 = $16 $326 $145 C$100 *. 80 = $80 $225 $30 $33 1 CD = $.75 1 CD = $.80 EBIT$38 $63

Increasing Canadian sales and lowering Canadian costs lowers exposure EBIT E $/CD Old Structure New Structure $43 $35.20 $40 $38

Searching for economic exposure Economic exposure is much more general than transaction exposure (it can come from many sources). Therefore, it can be much more difficult to find!  Exchange rates change market competition  Exchange rates are correlated with Macroeconomic conditions  Exchange rates change the value of foreign currency cash flows (transaction exposure)

Changes in currency prices can have all kinds of economic impacts. A general way to estimate economic exposure would be as follows: Percentage change in the exchange rate ($/F) Percentage change in cash flows (measured in home currency)

Regression Results VariableCoefficientsStandard Errort Stat Intercept % Change in Exchange Rate Regression Statistics R Squared.63 Standard Error1.20 Observations1,000 Every 1% depreciation in the dollar relative to the British pound lowers cash flows from England by 3.35%

Suppose you have three different facilities … Regression Results VariableCoefficientsStandard Errort Stat Intercept % Change in e ($/Euro) You first run a regression using consolidated income statements Plant A Plant B Plant C Overall, your cash flows are negatively related to the value of the Euro

Now, try isolating the exact location … Regression Results VariablePlant APlant BPlant C Coefficient T-Stat Now, run a regression using individual plant income statements Plant A Plant B Plant C Aha!!! Plant B is the culprit! (And they would’ve gotten away with it if it weren’t for those meddling kids!!!)

Now, try isolating the specific income statement items … Regression Results VariableSales Cost of GoodsExpenses Coefficient T-Stat Now, run a regression using individual plant income statements Plant B Ultimately, it looks like sales from plant B are the underlying currency problem Sales Costs of Goods Sold Operating Expenses

Now, what do we do about it?  Pricing Policy: If sales drop when the Euro appreciates, then consider lowering prices during strong Euro periods to maintain market share  Cash flow matching: If sales (and hence, cash inflows) are dropping during periods with a weak dollar, try adjusting production locations so that your costs will drop at the same time.  Futures, Forwards, and Options