Tài chính doanh nghiệp - Topic 9: Competitive exposure and real currency appreciation; managing country risk

Topic 9:cOMPETITIVE Exposure and real currency appreciatioN; Managing Country RiskL. GattisFinancial Risk Management1QuestionYou are a California wine producer that exports most of your wine to Canada. What is the California wine producers exposure to the euro?QuestionSuppose the euro devalues 5% against the dollar because euro inflation is 5% higher than the U.S.. Are California wine producers better or worse off?Learning ObjectivesStudents understand and can recallwhy changes in real exchange rates matterhow to measure competitive exposurehow to manage competitive exposureHow to manage country riskStudents can calculatereal exchange rate appreciationcompetitive exposure and loss due to exchange rate changes4Forex ExposureI. Translation “Accounting” Exposure arises when reporting and consolidating financial statements require conversion from foreign currency to home currency. It is a possible accounting gain/loss on foreign assets and liabilities which are reported as losses in income or adjustments to equity (Translation exposures often lead to cashflow losses when account are liquidated)II. Cashflow ExposuresTransaction Exposure: potential gains or losses on foreign transactions such as bond payments and receivables paid in the foreign currency. (Up until a payment is made, these are only translation exposures)Competitive Exposure: long-term exposure to currency change on future business.5Transaction vs. Competitive ExposureSuppose your U.S. based firm, produces widgets in Pennsylvania, which cost $100, and sells in Germany for €84 at an exchange rate of $1.25 per euro. Profit: Short-term Transaction Risk (cannot change cost or prices in the short-term)What are profits if the euro depreciates 10%?Profit= A. $0 B. $15.50 C. $5.50 D. -$5.50 E. -$15.50What was the USD appreciation?USD Appreciation= A. 10.0% B. 11.11% C. 9.09%6Transaction vs. Competitive ExposureLong-term Competitive Risk depends on your ability to adjust prices and/or costs What are profits if costs are lowered to $89.50 per widget?Profits: What are profits if they raise the euro price by the 11.11% USD appreciation and costs per widget are still $100?Profits: How can firms raise pricesDifferentiate product (“super” widgets)If euro depreciation was due to euro inflation, you can raise your prices in line with euro prices (not changing relative prices and competitive position)Implied Euro Inflation is 11.11% if dollar appreciations 11.11% (assuming US inflation = 0): PPP: $1.125/1.25 = (1+0)/(1+i€); i€=11.11%7Competitive Exposure and Real AppreciationCompetitive exposure is a firm’s long-term exposure to a currency appreciationIn the long run, firms can change prices and costsNominal Currency Appreciation is the percentage change in the stated exchange ratesReal Currency Appreciation is the percentage change in the stated exchange rates adjusted for changes in relative inflationApproximation: If euro depreciates 10% and the euro inflation was 10% higher – there is no change to the real exchange rate and firms are not better or worse offWhy: an American exporter to Germany receives less 10% less USD if the euro depreciates, but they can raise prices (by the relative inflation) to offset the nominal depreciation8Currency Real Appreciation CalculationsThe real exchange rate @ time-t is the nominal (quoted) rate @ time-t adjusted for changes in the relative inflation from time-0 to time-tNominal “stated” rate Real appreciation (of denominator currency) from time-0 to time-tIn the widget example: the nominal rate @t fell to 1.125, but the real rate @t was still 1.25There was no real appreciation of the euro, so the firm was not affected by nominal change9Concept CheckSuppose the Australian dollar appreciates 10% -- from $.90 to $.99. Over that period, inflation in the U.S. was 5% and inflation in Australia was 10%. What was the real appreciation of the Aussie?-15.2%-5%0+5%+15.2%10Real Appreciation – Indirect Quote Example: between 1980 and 1995, the Yen/$ rate moved from 226 Y/$ (or $.004425) to 93.96 Y/$ (or $.010643). During the same 15 year period the CPI in Japan rose from 91.0 to 119.2 and the U.S. CPI rose from 82.4 to 152.4. What happened to the real value of the Yen? Hint: first, convert the rates into $/Y and solve for real exchange rate in 1995.11Understanding Real AppreciationReal appreciation is the nominal appreciation from the PPP expected value. Example: Expect a currency to devalue 5% due to higher relative inflation, but currency actually appreciates 10%. This is approximately a 15% real appreciationIn this example, Australian export prices (in USD) to America are 15% higher10%: from nominal appreciation of currency5%: because Australian costs are 5% higher due to inflationSources of real appreciations (Why PPP/IRP would not hold)Government interventionSpeculationInflation measurement issuesDifferent baskets, non-tradeable goods12Measuring Competitive ExposureMeasuring the Competitive exposure to an exchange rate change is very difficult. You must estimate:Nominal exchange rate changesInterest rates, inflation rates, government intervention, supply and demand shocks, geo-political-economic riskRelative InflationPrice Flexibility (Yours and competitors)Cost Flexibility (Yours and competitors)13Managing Competitive RiskPricing StrategyAnticipate real exchange rate changes and be ready to adjust prices (if you can)Marketing StrategyDifferentiation, niche marketsProduction StrategyProduct deletionsShift production / plant relocationsProductivity14Managing Competitive Exposure4. Funding Strategyforeign currency denominated debt5. Human Resource StrategyBonus contracts that adjusts to unexpected real exchange rate changes. Inform management of expected real changes.6. Accounting StrategyMake foreign currency the FASB-52 functional currency7. Hedge with Derivatives Many firms only hedge short-term “known” exposures where prices and costs are fixed. Often 1-2 years of exposure.15Japan’s Lessons for ChinaChina is preventing its currency from appreciating in real and nominal terms to safeguard it export sectorPositive Effects: Exports prices low to foreignersNegative Effects: stronger yuan would increase the Chinese’ global purchasing power, inflationaryMany feel that this policy is not sustainable and the Yuan will eventually appreciate in real and nominal termsJapan’s Lessons for China (Dealing with real rate changes)Create high quality products (to raise prices) “TCL”Increase productivity (High tech, education, automation)Allow exchange rates to float so firms have more time to reactMove production to cheaper locations16Country Risk17Country Risk is a term for the risk of operating in a foreign country. These risks include, but are not limited to:Currency crisisTransaction, Translation, CompetitivePolitical RiskExpropriationChanges in taxation (home or host)Trade Barriers (Tariffs, Quotas)Changes in regulationLegal riskLitigationProperty Rights, Patents, CopyrightEconomyInflation and Exchange rate riskEconomic crisisTerrorism, Violence, CrimeInfrastructure failures (power, transportation, communication, etc.) Country Risk Measures18AON Political Risk Map - 2010Managing Country Risk During Capital Budgeting19 Account for country risk in NPV – cashflows or discount rate – to ensure compensation for risk Diversify across nations and regions Avoid/Delay Investments if environment too risky Obtain Federal Insurance: OPIC (Overseas Private Investment Corp)Managing Country Risk During Financing20Structure the investment to minimize exposureObtain outside financing: World Bank, Regional Development Bank, IMF, Foreign Government, Foreign BankPartners, Joint Ventures, LicensingProject FinanceMinimize/delay own financingFinance foreign projects using foreign denominated debt. If foreign currency devalues, falling US$ price of foreign assets is offset by falling liability values and US$ financing costs.Managing Risk During Operations21Function Currency = Local Currency (Translation Exposure)Managing balance sheetDevelop local stakeholdersLocal banks, employees, suppliers, etc.Maximize reliance/dependence on firmTax Arbitrage (subsidiary-subsidiary, and parent-subsidiary)Transfer pricing, retain profits abroad, disguise profits, transfer profits, Use DerivativesAssigned ProblemsThe value of the euro drops from $1.25 to $1.15 while inflation in the U.S. was 10% and the inflation in Europe was 5%. What was the real appreciation or depreciation of the euro? The USD - Canadian dollar exchange rate falls from C$1.05/USD to C$0.95/USD. Inflation in the U.S. and Canada was 4% and 2%. What should have the exchange rate changed to according to PPP? What was nominal and real appreciation of the USD? What was nominal and real appreciation of the Canadian dollar? Are U.S. or Canadian exporters worse off? Why?The peso per euro exchange rate rises from P15 to P18. Inflation in Mexico and Europe was 30% and 5% over that time. What should have the exchange rate changed to according to PPP? What was nominal and real appreciation of the euro? What was nominal and real appreciation of the peso? Are U.S. or Canadian exporter worse off? Why? 22TextbookShapiro and Sarin’s Foundation of Multinational Finance 6th Ed. Chapter 10 covers operating exposure and (competitive) real exchange rates23