Transcript Forecast (% Change)

Assessing Exchange Rate
Risk: Part II
Exchange Rate Exposure
www.blades.com
BLADES Board & Skate arrived on
the action / extreme scene in 1990, and
quickly became a trusted source of
equipment and service to in-line
skaters, skateboarders, and
snowboarders.
BLADES got its start in New York and currently
operates 15 retail stores in New York, New Jersey,
Massachusetts and Pennsylvania.
Blades could cut costs by
importing lower cost
components from Thailand
Increasing competition
and rising costs have
lowered Blades’ profit
margins
Suppose that Blades makes an agreement to buy plastic
components sufficient to produce 72,000 pairs of
rollerblades from Thai manufacturers at a price of
THB 2,870 per pair. ($1 = THB 38.87). Payment is due
in one month (72,000*2,870 = THB 206.64 M)
Trend
Should Blades import components from
Thailand?
$75 Per Pair
At the current
exchange rate,
Blades could cut
their costs by 1.6%
by importing from
Thailand (a savings
of $90,000)!!
THB 2,870 per pair
(THB 1 = $ .0257)
THB 2,870 (.0257) = $73.75
$75 - $73.75
100 = 1.6%
$75
However, importing Thai components
creates a transaction exposure for Blades
THB 2,870 per pair
(THB 1 = $ .0257)
Costs ($) = e ($/THB) * 72,000* Costs (THB)
Random
Variable
Constants
We need to
estimate this!!
Regression Results
Variable
Coefficients
Standard Error
t Stat
Intercept
. 80
.02
40
Inflation
.80
.35
2.28
Regression Statistics
R Squared
.43
Standard Error
2.20
Observations
240
%e  a  b   *  
Every 1% difference between US inflation and Thai
inflation depreciates the dollar by .8%
US inflation is currently 1% (per month) while
inflation in Thailand is 2.25% (per month)
(1 – 2.25) = -1.25
% Change in e =.8 + 0.80 * (inf) + error
($/THB)
Mean = . 80
Mean = .80
Mean = 0
Std. Dev. = .02
Std. Dev. = . 35
Std. Dev. = 2.20
StdDev  (.02) 2  (.35) 2 (1.25) 2  (2.20) 2  2.25%
Forecast
Mean = -.2%
Std. Dev. = 2.25%
Your 95% confidence
interval for the (monthly)
percentage change in the
exchange rate is
[-4.7% , 4.3% ]
Assessing transaction exposure
THB 2,870 per pair
(THB 1 = $ .0257)
Costs ($) = e ($/THB) * 72,000*2,870 THB
Forecast (% Change)
Mean = -.2%
Std. Dev. = 2.25%
Costs
Mean = 72,000*2,870*.0257(1-.002)
= $5,300,026
Std. Dev. = .0225*72000*2870*.0256
= $119,250 (2.25%)
Assessing transaction exposure
THB 2,870 per pair
(THB 1 = $ .0257)
Costs ($) = e ($/THB) * 72,000*2,870 THB
Mean = $5,300,026
Std. Dev. = $119,250
You are 95% sure your costs will
be between:
$5,300,026 + 2*$119,250 = $5,538,526
and
$5,300,026 - 2*$119,250 = $5,061,526
Should Blades import components from
Thailand?
$75 Per Pair
THB 2,870 per pair
(THB 1 = $ .0257)
Mean = $5,400,000
Mean = $5,300,026
Std. Dev. = $0
Std. Dev. = $119,250
What do you do?
Blades is also thinking
about exporting
rollerblades to Thailand
Suppose that Blades makes an agreement to sell 30,000
pairs of roller blades to a Thai sporting goods store for
THB 4,500 apiece.
Trend
Assessing transaction exposure
Net Cash Flows($) = e ($/THB) * ( 72,000*2,870 - 30,000*4,500)
= e ($/THB) * ( 71,640,000THB)
Forecast (% Change)
Mean = -.2%
Std. Dev. = 2.25%
Net Cash Flows($)
Mean = 71,640,000*.0257(1-.002)
= $1,837,465
Std. Dev. = .0225*71,640,000*.0257
= $41,342 (2.25%)
Blades could also import
Japanese components.
Japanese components are
slightly more expensive
(Y 8,000 per pair = $74.77)
$1 = Y 107
Suppose that Blades splits its purchases
of components between Thailand and
Japan (Exports to Thailand = 0)
THB 2,870 per pair
(THB 1 = $ .0257)
THB 2,870*.0257*36,000 = $2,655,324
JPY 8,000 per pair
(JPY 1 = $ .0093)
JPY 8,000*.0093*36,000 = $2,678,400
$5,333,724
Forecast (% Change)
Forecast (% Change)
Mean = 0%
Mean = 0%
Std. Dev. = 2.25%
Std. Dev. = 3.50%
CORR = -.65
$2,655,324
= .49
$5,333,724
$2,678,400
$5,333,724
= .51
Net Cash Flows
Mean  $5,333,724
SD 
.492 .02252  (.51) 2 (.035) 2  2(.49)(.51)(.0225)(.035)( .65)  .014  1.4%
Cash flow Situation…
And the Currencies
are…
Currency
exposure
Equal Inflows of Two
Currencies
Positively Correlated
Equal Inflows of Two
Currencies
Uncorrelated
Equal Inflows of Two
Currencies
Negatively Correlated
Low
Inflow in one currency/outflow
in another
Positively Correlated
Low
Inflow in one currency/outflow
in another
Uncorrelated
Inflow in one currency/outflow
in another
Negatively Correlated
High
Moderate
Moderate
High
Importing from both Japan and Thailand can diversify
currency exposure!!
Suppose that Blades is planning to expand sales into
England. Should they try and contract sales in dollars
or Pounds?
Current
Forecast (% Change)
GBP 1 = $1.80
Mean = 0
SD = 2.0%
Contracting sales in GBP creates transaction
exposure. However, contracting sales in USD creates
economic exposure
Suppose that Blades agrees to sell roller blades
to England for $125 apiece. (GBP 70)
Current
Forecast (% Change)
GBP 1 = $1.80
Mean = 0
SD = 2.0%
Demand in England is as follows:
Q = 400 - 3P
P = Local price of
Roller blades
At a local price of GBP 70, demand equal 500 - 3(70) = 190
Q = 500 – 3P
P
Qd
%Qd
Qd
Qd P
d 


P
%P
P Qd
P
1%
70
1.1%
# Roller Blades
190
Elasticity of Demand refers to
the responsiveness of demand
to price changes (here, the price
is the interest rate)
Qd P
 70 
d 
 3
  1.11
P Qd
 190 
Suppose that Blades agrees to sell roller blades
to England for $125 apiece. (GBP 70)
Current
Forecast (% Change)
GBP 1 = $1.80
Mean = 0
SD = 2.0%
Revenues = Price ($) * Quantity
Constant
Forecast (% Change)
Mean = 0
SD = 2.0%*Elasticity = 2.2%
GBP Pricing (Transaction Exposure)
Revenues = e ($/L)* Price (L) * Quantity
Forecast (% Change)
Mean = 0
Constant
SD = 2.0
USD Pricing (Economic Exposure)
Revenues = Price ($) * Quantity
Constant
Forecast (% Change)
Mean = 0
SD = 2.0%*Elasticity = 2.2%
Changes in currency prices can have all kinds of
economic impacts. A more general way to estimate
economic exposure would be as follows:
PCFt  a  bet   t
Percentage change in cash
flows (measured in home
currency)
Percentage change in the
exchange rate ($/F)
Regression Results
Variable
Coefficients
Intercept
% Change in
Exchange Rate
Regression Statistics
R Squared
Standard Error
Observations
.63
Standard Error
t Stat
.05
1.5
.03
-3.35
.97
-3.45
PCFt  a  bet  
1.20
1,000
Every 1% depreciation in the dollar relative to the British
pound lowers cash flows from England by 3.35%
Suppose that Blades sets up a Thai
subsidiary. The Thai plant uses
locally produced components to
produce roller blades that will be
sold to local (Thai) customers.
Is Blades still exposed to currency risk?
Blades will need to produce consolidated cash flow and income
statements as well as a consolidated balance sheet. Translation
exposure refers to the impact of exchange rate changes on these
financial statements.
FASB Rule #52 (for US Based MNCs)
The functional currency of an entity is the currency of the economic
environment in which the entity operates
The current exchange rate as of the reporting date is used to translate
assets/liabilities from the functional currency to the reporting currency
The weighted average exchange rate over the relevant reporting period
is used to translate revenues, expenses, gains, and losses
Translated Gains/Losses are not recognized as current net income, but
are reported as a second component of stockholders’ equity
Should we be worried about this type of
exposure??
Examples of translation
exposure
Citigroup General Wall Mart
Motors
Net Income (2004) $17.04B
$3.8B
$9B
Company
Income
Gains/Losses due
to currency
changes
$731M
(4.3%)
$929M
(24%)
$320M
(3.5%)