International Business (MB 40) Exchange Rate Risk International Business (MB 40)

Outline Meaning of Exchange Rate Risk Types of Exchange Rate Risks Transaction Exposure Translation Exposure Economic Exposure Management of Exchange Rate Risk Management of Transaction Exposure Management of Economic Exposure

Meaning of Exchange Rate Risk Risk of fluctuating value of a currency over time Impacts dollar value of foreign currency cash inflows and foreign currency cash outflows If we have foreign currency cash inflows, we face risk of foreign currency depreciating against domestic currency If we have foreign currency cash outflows, we face risk of foreign currency appreciating against domestic currency

Types of Exchange Rate Exposures Transaction Exposure Only companies engaged in global business and doing transactions in foreign currency face this risk Arises due foreign currency transactions of a firm Arises from the possibility of incurring future exchange gains/losses on transactions already entered into and denominated in a foreign currency.

Translation Exposure The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations If the assets/liabilities are translated at something other than the historical exchange rates, the Balance Sheet will be affected by fluctuations in currency values over time

Economic Exposure structure of markets for a firm’s product The extent to which the economic value of a company can decline because of exchange rate changes Decline can be due to a decline in the level of expected cash flows or an increase in the riskiness of these cash flows Overall effect of exchange rate changes in competitive relationships between alternative foreign locations Extent of exposure depends on structure of markets for a firm’s product Price elasticity of demand for the product Availability of close substitutes for the product Even pure domestic firms may face economic exposure

Management of Transaction Exposure Foreign currency cash outflows Risk: Foreign currency may become more expensive/appreciate against domestic currency Strategy: Buy foreign currency futures, forwards, or call options Foreign currency cash inflows Risk: Foreign currency may become more cheap/depreciate against domestic currency Strategy: Sell foreign currency futures, forwards, or buy put options

Management of Economic Exposure Marketing Initiatives Market Selection Pricing Strategy Product Strategy Promotion Strategy Production Initiatives Product sourcing and input mix Plant location Raise Productivity Financial Initiatives

Marketing Initiatives Shall we pull out of a market that has been rendered unprofitable due to competition or shall we differentiate the product and concentrate on specific customers only? Shall we emphasize market share or profit margin in response to weak domestic currency? Shall we add/drop a product to our product line in response to exchange rate changes? Where to advertise?

Production Initiatives Outsource your inputs/raw materials/components in response to strong domestic currency Change input mix to reduce cost in response to strong domestic currency Shift production to weak currency area in response to strong domestic currency Raise productivity by cutting costs—produce the same number of units at a lower cost or produce more units at the same cost

Financial Initiatives Equate the sensitivity of costs and revenues to exchange rate changes