Transcript operating_exposure

Operating Exposure
International Corporate Finance
P.V. Viswanath
Learning Objectives
 The implications of exchange rates for the revenues, costs,
and profits of companies invovled in international
commerce.
 Factors affecting the impact of exchange rates on profits
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elasticity of demand for a company’s products,
the types of inputs used,
The use of internationally traded inputs
Flexibility of production to meet changes in demand
Time span consdiered
Degree of competition faced in markets where the goods are sold
 Even a company with hedged receivables and payables can
be affected by foreign exchange exposure.
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Competitive markets in the short run
 An exporting firm in a competitive market will experience
an increase in sales revenues and production costs after a
real depreciation of its currency.
 If the new price is determined in the export market, the
dollar price will rise by the amount of the depreciation.
 This will lead to an expansion of production.
 Consequently, total revenue will rise by more than total
costs and so profits will increase.
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Long-run effects: tradable inputs
 The higher profit for a competitive firm from devaluation
will encourage existing (domestic) firms to expand output
and new (domestic) firms to enter the industry, lowering the
product price.
 This may limit the period of extra profit for an particular
pre-existing firm.
 If some of the inputs are internationally tradable, the
depreciation will cause their dollar prices to rise.
 Similarly, the depreciation may lead to general inflation and
competition for inputs, leading to higher production costs.
 This will also limit profit improvements
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Imperfect competition
 An exporting firm in an imperfectly competitive market will
experience an increase in total revenue and total cost after devaluation
when amounts are measured in the firm’s home currency.
 The (home) price will rise by less than the currency depreciation
because of the downward sloping demand curve.
 However, this will partly be compensated for by increased sales, so
that revenues will still rise.
 A firm must be sufficiently flexible in terms of its production plans,
else it will not be able to take advantage of the potential for higher
sales.
 Total costs will rise in the short run if the cost curve is upward
sloping. Still, revenue will rise by more than total cost, and so profit
will increase.
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The role of demand elasticity
 Exactly how much of a price reduction will be required (in terms of
the foreign currency price) will depend upon the price elasticity of
demand for the good.
 If demand is very elastic, a small decrease will be sufficient to cause
demand to go up a lot. This will mean that the exporter’s profits will
be higher.
 The flip side of this is that if there is an appreciation of the home
currency, the hit on profits will be large, as well.
 Consequently, the more elastic the demand for the good, the greater
the exposure of the exporter to exchange rate changes of a given
volatility.
 Marketing/Advertising may be useful in creating brand loyalty and
reducing the price elasticity of demand for the firm’s products.
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Imperfect competition
 In the longer run, the higher profits can persist if they are
not offset by higher input costs in the form of greater
competition and costlier traded inputs.
 Revenues, costs, and profits that are measured in terms of
foreign exchange will also increase from devaluation,
although by a lesser amount.
 This is because domestic exporters will be able to produce
cheaper in terms of the foreign currency. Hence, they will
have a higher profit margin.
 However, if there is competition, the foreign currency price
might even drop. This parallels the fact that the price rise in
the domestic currency will be less than the percentage of
depreciation.
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Pricing Flexibility
 The key issue for a domestic firm, when the dollar
appreciates is its pricing flexibility.
 Can it maintain its dollar margins both at home and
abroad?
 Can it maintain its dollar price on domestic sales in
the face of lower-priced foreign imports?
 In the case of foreign sales, can the firm raise its
foreign currency selling price to preserve its dollar
profit margin?
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Price Elasticity of Demand
 The less price elastic the demand for the company’s
products, the more price flexibility the company has.
 Price elasticity depends on the degree of competition and the
location of key competitors.
 The more differentiated a company’s products are, the less
competition it will face. (e.g. Mercedes Benz cars)
 If most competitors are based in the home country, then all
will face the same change in their cost structure, and no one
producer will be at a disadvantage vis-à-vis any other
domestic producer.
 Commodity exporters are very vulnerable to real exchange
effects because of the non-differentiated nature of their
products.
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More about Flexibility
 The firm’s susceptibility to exchange rate risk depends also
on its ability to shift production and the sourcing of inputs
among countries.
 A foreign subsidiary selling goods in its local market cannot
increase local prices enough to make up for a local currency
devaluation. However,
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the devaluation will also help in fending off import competition.
the dollar value of local production costs will drop; however, the
higher the import content of local inputs, the less dollar production
costs will decline.
 if the firm can substitute local inputs for imported inputs, it
can cope better with the devaluation.
 if the firm can sell in other markets, it can keep dollar
revenues high.
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The Case of Importers
 Devaluation raises the prices of imports in terms of the
devalued currency and reduces the quantity that is imported
and sold.
 Total revenue and total cost in terms of dollars will fall, and
so will the importer’s profit.
 A revaluation lowers input prices and raises an importer’s
dollar total revenue, total cost, and profit.
 Devaluation lowers the prices of imports when these prices
are measured in the foreign currency.
 Dollar devaluation lowers an importer’s total revenue, total
cost, and profit in terms of the foreign currency.
Revaluation will raise them.
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The effect of hedging on exporters
 When an arrangement exists to export a stated quantity at a
price fixed in home currency, devaluation can temporarily hurt
an exporter’s profit. This is true in both dollar and foreigncurrency units.
 This is because costs are still susceptible to exchange rate
effects. If some of the inputs are internationally traded, costs
will rise while revenues will not be helped. Similarly,
competition among producers, as well as general inflation
could raise input costs.
 If prices in an export sales agreement are stated as foreigncurrency amounts and these are not sold forward, devaluation
will raise dollar revenues, costs, and profits of a US exporter
via both transaction and operating exposure.
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The effect of hedging on importers
 An importer buying an agreed-upon quantity at an
agreed-upon price in dollars will experience no
change in dollar revenues, costs, or profits after
devaluation.
 An importer buying an agreed-upon quantity at
prices invoiced in foreign exchange will
temporarily experience unchanged dollar revenues,
increased costs, and reduced profits.
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Measuring Exposure: Practical solutions
 Suppose stock price information is not available,
but profit/income data is available
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Incomes can be regressed against exchange rate changes
to get a measure of the flow effect.
The present value of the effect on income must be
computed to get the exposure measure.
 Another approach is to create scenarios by talking
to senior management to see how profits would be
affected by exchange rate changes.
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