Description
This is a PPT about Operating Exposure to Exchange rate changes.
Note on Operating Exposure to Exchange rate changes
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During the oil shock of the 70s the oil price changed relative to other goods Manufacturing costs changed, consumption pattern changed, some technologies changed etc Large unexpected changes in the exchange rates can have a similar impact The impact of large unexpected changes in the value of firms’ expected future operating cash flows
PPP and real exchange rates
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Real change in exchange rates change the relative prices of the goods and services consumed and produced by firms Relative prices do not change when changes in exchange rates correspond to differences in inflation PPP is NOT a good explanation of exchange rate movements, except in the very long run When PPP does not hold relative prices of manufacturing inputs like labor and hence cash flows may change
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It is possible to have a real exchange rate shock even when observed nominal rates are constant: when inflation changes, nominal must, else real rate must That is, firms have operating exposure even under fixed exchange rate regime Relative prices can change for reasons other than exchange rates (technological or demographic changes)
The responses of operating cash flows
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Consider a US firm that sells in the US and Germany Imports none of the inputs and exports half of the output D unexpectedly appreciates against the DM and is real What happens to the cash flows of the firm?
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First, a currency must be chosen to measure cash flows USD is the likely candidate Inputs are sourced from the US; unaffected by rate change as they are measured in dollars Let USD price and unit volume remain the same in the US When the firm exports to Germany, it must set a price in DM for its products Can either leave the price constant or raise the DM price to offset fully the DM depreciation
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If DM prices are held constant, consumers may continue to purchase; unit volume remains constant; as also DM revenue. But $ returns change If DM prices are raised, unit volumes may or may not come down; may lead to drop in $ cash flow Either way, there is a drop in $ cash flow
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The $ cash flow is negatively exposed to the real DM/$ rate When the real rate goes up, $ cash flows of the firm decline Real home currency appreciation reduces cash flow of home country firms engaged in exporting or competing at home
Important Extensions
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Yen/$ rate has been over 270 and under 140 Consumer Reaction: Firm may experience both an increase in US demand and a decrease in German demand depending on relative importance to the firm of the two markets Competitors reaction: German firms may find labor relatively cheaper; may use price-based competition or keep DM prices and margins up, thereby increasing DM profits. If competition comes from other US exporters, none of them will obtain a cost advantage
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Supplier reactions: Those firms that import more may, for example, have a cost advantage when the real home currency appreciates even if they don’t export Size of advantage depends on supplier reaction The nature of competition among suppliers also must be examined (their locations, cost structures, types of demand all matter) For example, when USD appreciates, German laborers may demand higher compensation; so German labor may become as expensive as that in the US
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Public sector reactions: when oil price changed, US government taxed old oil, introduced incentives for exploration and conservation, invested in alternate energy Similarly, government may resort to protectionist trade regime, tax breaks, to control currency flow/foreign investment etc when exchange rates change
Summary
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Home currency appreciation hurts exports Home currency depreciation’s effect is complicated by reaction of consumers, suppliers and government
Further extensions
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Changes in real exchange rates are often accompanied by changes in real interest rates PV of the firm may not change Competitors’ reactions are difficult to anticipate Total cash flows and marginal cash flows can have opposite signs Revenues may be positively exposed, costs may be highly negatively exposed; overall negative exposure If substantial portion of costs are fixed, marginal cash flows may be negatively exposed A firm’s total operating exposure depends on its competitors’ (and suppliers’) marginal exposures
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Actions of the firm and competitors depends on the exposure of suppliers and competitors’ marginal cash flows in all markets Operating exposure also affects the cash flows from future investments; i.e. it alters the exercise price of the real call option
Managing Operating Exposure
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Three steps: Understand how it works Estimating signs and magnitudes Do something about it Estimating exposure is difficult; change from year to year/quarter to quarter Can do an exposure audit Careful examination of separate elements of a firm’s operating cash flows and to anticipate the impact of exchange rate changes
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A regression of changes in firm value on changes in exchange rates gives a statistical estimate of exposure Advantage is that data is observable and is of high quality Drawback is that it gives aggregate exposure not a view of different elements of the exposure How should a firm respond?
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Pricing, sourcing, product mix etc Kind of an organizational rehearsal
doc_371719153.ppt
This is a PPT about Operating Exposure to Exchange rate changes.
Note on Operating Exposure to Exchange rate changes
?
?
?
?
During the oil shock of the 70s the oil price changed relative to other goods Manufacturing costs changed, consumption pattern changed, some technologies changed etc Large unexpected changes in the exchange rates can have a similar impact The impact of large unexpected changes in the value of firms’ expected future operating cash flows
PPP and real exchange rates
?
?
?
?
Real change in exchange rates change the relative prices of the goods and services consumed and produced by firms Relative prices do not change when changes in exchange rates correspond to differences in inflation PPP is NOT a good explanation of exchange rate movements, except in the very long run When PPP does not hold relative prices of manufacturing inputs like labor and hence cash flows may change
?
?
?
It is possible to have a real exchange rate shock even when observed nominal rates are constant: when inflation changes, nominal must, else real rate must That is, firms have operating exposure even under fixed exchange rate regime Relative prices can change for reasons other than exchange rates (technological or demographic changes)
The responses of operating cash flows
?
?
?
?
Consider a US firm that sells in the US and Germany Imports none of the inputs and exports half of the output D unexpectedly appreciates against the DM and is real What happens to the cash flows of the firm?
?
? ?
?
?
?
First, a currency must be chosen to measure cash flows USD is the likely candidate Inputs are sourced from the US; unaffected by rate change as they are measured in dollars Let USD price and unit volume remain the same in the US When the firm exports to Germany, it must set a price in DM for its products Can either leave the price constant or raise the DM price to offset fully the DM depreciation
?
?
?
If DM prices are held constant, consumers may continue to purchase; unit volume remains constant; as also DM revenue. But $ returns change If DM prices are raised, unit volumes may or may not come down; may lead to drop in $ cash flow Either way, there is a drop in $ cash flow
?
?
?
The $ cash flow is negatively exposed to the real DM/$ rate When the real rate goes up, $ cash flows of the firm decline Real home currency appreciation reduces cash flow of home country firms engaged in exporting or competing at home
Important Extensions
? ?
?
Yen/$ rate has been over 270 and under 140 Consumer Reaction: Firm may experience both an increase in US demand and a decrease in German demand depending on relative importance to the firm of the two markets Competitors reaction: German firms may find labor relatively cheaper; may use price-based competition or keep DM prices and margins up, thereby increasing DM profits. If competition comes from other US exporters, none of them will obtain a cost advantage
?
? ?
?
Supplier reactions: Those firms that import more may, for example, have a cost advantage when the real home currency appreciates even if they don’t export Size of advantage depends on supplier reaction The nature of competition among suppliers also must be examined (their locations, cost structures, types of demand all matter) For example, when USD appreciates, German laborers may demand higher compensation; so German labor may become as expensive as that in the US
?
?
Public sector reactions: when oil price changed, US government taxed old oil, introduced incentives for exploration and conservation, invested in alternate energy Similarly, government may resort to protectionist trade regime, tax breaks, to control currency flow/foreign investment etc when exchange rates change
Summary
?
?
Home currency appreciation hurts exports Home currency depreciation’s effect is complicated by reaction of consumers, suppliers and government
Further extensions
? ? ? ?
?
?
?
Changes in real exchange rates are often accompanied by changes in real interest rates PV of the firm may not change Competitors’ reactions are difficult to anticipate Total cash flows and marginal cash flows can have opposite signs Revenues may be positively exposed, costs may be highly negatively exposed; overall negative exposure If substantial portion of costs are fixed, marginal cash flows may be negatively exposed A firm’s total operating exposure depends on its competitors’ (and suppliers’) marginal exposures
?
?
Actions of the firm and competitors depends on the exposure of suppliers and competitors’ marginal cash flows in all markets Operating exposure also affects the cash flows from future investments; i.e. it alters the exercise price of the real call option
Managing Operating Exposure
? 1) 2) 3) ?
? ?
Three steps: Understand how it works Estimating signs and magnitudes Do something about it Estimating exposure is difficult; change from year to year/quarter to quarter Can do an exposure audit Careful examination of separate elements of a firm’s operating cash flows and to anticipate the impact of exchange rate changes
?
?
?
?
A regression of changes in firm value on changes in exchange rates gives a statistical estimate of exposure Advantage is that data is observable and is of high quality Drawback is that it gives aggregate exposure not a view of different elements of the exposure How should a firm respond?
? ?
Pricing, sourcing, product mix etc Kind of an organizational rehearsal
doc_371719153.ppt