A brief introduction to

Economic Exposure

Sept 11, 2009 14.30 to 18.40 hours Slide 1

 The short term impact
 When exchange rates change, there is an immediate impact on transactions.
 
 Consider an Indian firm which has contracted to buy machinery worth $ 100,000.
 
 The exchange rate is currently Rs 66.50/$. Suppose the exchange rate changes to Rs.67.50/$.
 
 If the exposure had been left uncovered, the company will have to pay Rs. 100,000 more.
 
 Similarly, consider an Indian exporter expecting receivables of $ 100,000. He would have benefited by Rs.
100,000 for an identical change in exchange rates.
 
 This type of exposure is referred to as transaction exposure and its impact is more immediate, palpable and
direct.

Sept 11, 2009 14.30 to 18.40 hours Slide 2

 The medium and long term impact
 In the medium to long run, the change in exchange rates through their impact on prices will also affect
demand.

 If the dollar appreciates (and continues to appreciate) against the rupee, imports from USA will
become more expensive.
 
 As a result, the demand will decrease, with the extent of decrease depending on the price elasticity of
demand.
 
 While considering the long term impact on profits, both price and demand have to be considered.
 
 This type of exposure is referred to as economic exposure.

Sept 11, 2009 14.30 to 18.40 hours Slide 3

 De-risking the Dollar

Sept 11, 2009 14.30 to 18.40 hours Slide 4

 The killer effect
 Transaction Risk (Exposure) and Economic Risk (Exposure) are of the same kind, but differ hugely in
impact

 In a way, Economic Risk is subjective and depends on future cash flows for an arbitrary time horizon.
Whereas, Transaction risk is very immediate and objective. No one can dispute the existing financial
obligation for past contracted events

 There are some significant differences between Transaction Risk and Economic Risk, which
essentially brings out the killer impact of the latter.

 The differences are summarised in the next slide

Sept 11, 2009 14.30 to 18.40 hours Slide 5

 TRANSACTION EXPOSURE ECONOMIC EXPOSURE
Very specific to a contract and arises due to Very general in nature and covers the entire
 
 
present obligations on past transactions business and not one particular transaction
Opportunity losses caused by changes in
Simple to compute the impact. The impact is
exchange rates are difficult to estimate. You need
one time and the parameters are readily  
mathematical models for isolation of 'price
available
  elasticity'
Corporates cannot put in place policies to handle
Corporates put in place policies to handle
Economic Exposure. This risk has to be
Transaction Exposures. Various derivatives are  
confronted with Business Strategy rather than
also available to hedge this risk
  financial policy

Transaction Exposure can be avoided by

Economic exposure handling needs good strategic
counter-party arrangements, such as 'currency  
planning
of invoice' model
 

Risk exposure extends to the time taken for

Risk Exposure is limited to contract period
  restructuring operations - changing product mix,
exposure
markets, sourcing of raw materials, technology, etc
 

Generally the risk is restricted to a contract's The Risk extends to cash flows arising from
commercial terms - either revenue receipt or   cumulative impact of cost, volume price
purchase price relationship
 

Therefore, the only source of uncertainty is the Many sources arising from the future exchange
 
future exchange rates rate impinging on sales, prices and costs
 

Sept 11, 2009 14.30 to 18.40 hours Slide 6

 Price Elasticity
 The important point to be kept in mind is that the demand for a commodity in a country depends on the price in home currency
units.
 Thus, for an Indian importer, the demand depends on the rupee price and not on the dollar price.  
 In this context, the currency of invoicing becomes relevant.
 Consider an Indian company exporting garments to the US. If the invoicing is done in $, irrespective of any change in the $=Re
exchange rate, the price per unit paid by the American customers in their home currency remains the same. Thus, the exchange
rate changes make no difference to the importer.  However, there is a short term transaction exposure; but more importantly
there is an economic exposure for the Indian exporter
 However, the story does not stop here. The Indian Exporter has further opportunities in a risk
 The Indian exporter may reduce the dollar price if he is happy with the existing profit margin, as a result in fluctuation of the
USD (if USD appreciates against INR). As a result, US customers might find the product to be more attractive and the demand
might increase leading to a long term economic impact.
 Similar arguments can be applied in the case of an Indian importer.

Sept 11, 2009 14.30 to 18.40 hours Slide 7

 How to address Operating Exposure
 Very difficult !
 Has to address using ‘strategic options’ (alternatives)
• Diversifying sales }
• Diversifying location of manufacturing facilities } Diversifying operations
• Diversifying location of sourcing raw materials }
• Raising capital from more than one market ] Diversifying financial
• Raising capital in more than one currency ] alternatives

 Operating exposure creates future cash flow disequilibrium – which can be positive or negative. If the
result in future is negative, active responses are necessary; however, if the result is positive, even then
active responses will be necessary because the benefits are likely to be short term; the long term effect
can be crippling.
 Some of the techniques used by MNCs to counter Operating exposure are briefly explained in the
next slide

Sept 11, 2009 14.30 to 18.40 hours Slide 8

 Management of Operating Exposure
 Matching currency cash flows
• Using financing alternatives
• Using raw material sourcing alternatives
• Pooling of cash flows
• Establishing invoicing centers
 Leading and lagging of receivables and payables
• Inherently a risky strategy
 Risk sharing clauses in contracts for long term
• Possible with long term customers
 Back to Back loans between parent companies
 Currency Swaps
 Long term currency hedging, provided products are available in the markets

Sept 11, 2009 14.30 to 18.40 hours Slide 9

 THE
END OF
CLASS

Sept 11, 2009 14.30 to 18.40 hours Slide 10