ECONOMIC

EXPOSURE
 ECONOMIC / OPERATING EXPOSURE?
• Economic exposure refers to any impact of the exchange rate
fluctuations towards a firm’s future cash flows (cash flows from
operations/assets/liabilities).
• Exchange rate changes are often linked to variability in real growth,
inflation, interest rates, governmental actions and etc.
• Changes in exchange rates can affect not only firms that are directly
engaged in international trade but also purely domestic firms.
• Thus, it is difficult to measure precisely and hence challenging to hedge.
 HOW TO MEASURE ECONOMIC EXPOSURE
• Economic exposure can be measured by using statistical measurements
of sensitivity by calculating
 Sensitivity of the future home currency values of the firm’s assets and
liabilities to random changes in exchange rates.
 Sensitivity of the firm’s operating cash flows to random changes in
exchange rates.
 HOW TO MEASURE ECONOMIC EXPOSURE
• A regression on the (home) ringgit value (P) of foreign assets on the
ringgit exchange rate, i.e. S(RM/£), the regression would be of the form:
P = ⍺ + 𝛽S + 𝜺
Where:
⍺ is the regression constant
𝜺 is the random error term with mean zero
𝛽 is the regression coefficient and measures the sensitivity of the ringgit
value of the assets (P) to the exchange rate, S.
 HOW TO MEASURE ECONOMIC EXPOSURE
• The exposure coefficient, b, is defined as follows:
b = Cov(P,S)
Covariance is a measure of
how much two variables
Var(S) change together
Where:
Cov(P,S) is the covariance between the ringgit value of the asset and the
exchange rate, and Var(S) is the variance of the exchange rate.
A measure of the degree to which returns on two risky assets move in
tandem. A positive covariance means that asset returns move together. A
negative covariance means returns move inversely.
 HOW TO MEASURE ECONOMIC EXPOSURE
• The exposure coefficient shows that there are two sources of economic
exposure:
1. The variance of the exchange rate and
2. The covariance between the ringgit value of the asset and exchange
rate.
b = Cov(P,S)
Var(S)
 EXAMPLE
• Suppose a Malaysian firm has an asset in Britain whose local currency
price is random.
• For simplicity, suppose there are only three states of the world and each
state is equally likely to occur.
• The future local currency price of this British asset (P*) as well as the
future exchange rate (S) will be determined, depending on the realized
state of the world.
 EXAMPLE (cont.)
State Probability P* S S x P*
Case 1:
1 1/3 £980 RM1.40/£ RM1,372
2 1/3 £1,000 RM1.50/£ RM1,500
3 1/3 £1,070 RM1.60/£ RM1,712
Case 2:
1 1/3 £1,000 RM1.40/£ RM1,400
2 1/3 £933 RM1.50/£ RM1,400
3 1/3 £875 RM1.60/£ RM1,400
Case 3:
1 1/3 £1,000 RM1.40/£ RM1,400
2 1/3 £1,000 RM1.50/£ RM1,500
3 1/3 £1,000 RM1.60/£ RM1,600
 EXAMPLE (cont.)
State Probability P* S S x P*
Case 1:
1 1/3 £980 RM1.40/£ RM1,372
2 1/3 £1,000 RM1.50/£ RM1,500
3 1/3 £1,070 RM1.60/£ RM1,712

• In case 1, local currency price of assets and exchange rate are positively correlated.
• This gives rise to substantial exchange rate risk.
 EXAMPLE (cont.)
State Probability P* S S x P*
Case 2:
1 1/3 £1,000 RM1.40/£ RM1,400
2 1/3 £933 RM1.50/£ RM1,400
3 1/3 £875 RM1.60/£ RM1,400

• In case 2, local currency price of assets and exchange rate are negatively correlated.
• This offsets the exchange rate risk substantially. (Completely in this example).
 EXAMPLE (cont.)
State Probability P* S S x P*
Case 3:
1 1/3 £1,000 RM1.40/£ RM1,400
2 1/3 £1,000 RM1.50/£ RM1,500
3 1/3 £1,000 RM1.60/£ RM1,600

• In case 3, local currency price of assets are fixed at £1,000.

• This “contractual” exposure can be completely hedged (making an investment to
reduce the risk adverse price movements in an asset).
 MANAGING ECONOMIC/OPERATING EXPOSURE
• As the economy becomes increasingly globalized, many firms are engaged in
international activities such as exports, cross-border sourcing, joint ventures
with foreign partners and etc.
• So managing the economic exposure is thus not a short-term issues. It involved
long term strategic planning as follows:
 Selecting low-cost production site

 Flexible sourcing policy

 Diversification of the market

 Product differentiation and R&D efforts

 Financial hedging
 SELECTING LOW-COST PRODUCTION SITES
• When domestic currency is strong or expected to become strong, frim
can choose to locate production facilities in a foreign country.
• A firm may wish to diversify the location of their production sites to
diminish the effect of exchange rate movements.
• E.g. Japanese car maker (Nissan and Toyota) have been increasingly
shifting their production to Thailand manufacturing facilities to mitigate
the negative effect of the strong yen.
 FLEXIBLE SOURCING POLICY
• Even if the firm has facilities only in domestic country, it can lessen the
effect of exchange rate by sourcing from where input costs are low or
buy parts where produced the cheapest.
• Doesn’t only apply to components, but also to “guest workers”.
• E.g. Japan Air Lines hired foreign crews to remain competitive in
international routes in the face of a strong yen, but later contemplated a
reverse strategy in the face of a weak yen.
 DIVERSIFICATION OF THE MARKET
• Another way of dealing with exchange exposure is to diversify the
market for the firm’s product as much as possible. E.g. Malaysian firm
will increase sales in Mexico if ringgit is appreciate against peso and
reduce sales in Japan if ringgit depreciate against yen. As a results,
overall cash flows will be more stable.
• It sometimes argued that the firm can reduce currency exposure by
diversifying across different business lines.
 R&D AND PRODUCT DIFFERENTIATION
• Successful R&D efforts allow the firm to cut cost and enhanced
productivity.
• R&D efforts can lead to the introduction of new and unique products.
Since the DD for unique products is inelastic (i.e price is insensitive),
therefore the firm should be less exposed to exchange rate risk.
 FINANCIAL HEDGING
• Financial hedging can be used to stabilize the firm’s cash flow
• Financial hedging involves use of derivative securities such as currency
swaps, futures, forwards, currency options, among others.