International Finance - Economic Exposure

Economic exposure is the toughest to manage because it requires ascertaining future exchange rates. However, economists and investors can take the help of statistical regression equations to hedge against economic exposure. There are various techniques that companies can use to hedge against economic exposure. Five such techniques have been discussed in this chapter.

It is difficult to measure economic exposure. The company must accurately estimate cash flows and the exchange rates, as transaction exposure has the power to alter future cash flows while fluctuation of the currency exchange rates occur. When a foreign subsidiary gets positive cash flows after it corrects for the currency exchange rates, the subsidiary’s net transaction exposure is low.

Note − It is easier to estimate economic exposure when currency exchange rates display a trend, and the future cash flows are known.

Regression Equation

Analysts can measure economic exposure by using a simple regression equation, shown in Equation 1.

P = α + β.S + ε (1)

Suppose, the United States is the home country and Europe is the foreign country. In the equation, the price, P, is the price of the foreign asset in dollars while S is spot exchange rate, expressed as Dollars per Euro.

The Regression equation estimates the connection between price and the exchange rate. The random error term (ε) equals zero when there is a constant variance while (α) and (β) are the estimated parameters. Now, we can say that this equation will give a straight line between P and S with an intercept of (α) and a slope of (β). The parameter (β) is expressed as the Forex Beta or Exposure Coefficient. β indicates the level of exposure.

We calculate (β) by using Equation 2. Covariance estimates the fluctuation of the asset's price to the exchange rate, while the variance measures the variation of the exchange rate. We see that two factors influence (β): one is the fluctuations in the exchange rate and the second is the sensitivity of the asset's price to changes in the exchange rate.

β =
Covariance (P,S) / Variance (S)

Economic Exposure – A Practical Example

Suppose you own and rent out a condominium in Europe. A property manager recruited by you can vary the rent, making sure that someone always rents and occupies the property.

Now, assume you receive € 1,800, € 2,000, or € 2,200 per month in cash for rent, as shown in Table 1. Let’s say each rent is a state, and as is obvious, any of the rents have a 1/3 probability. The forecasted exchange rate for each state, which is S has also been estimated. We can now calculate the asset's price, P, in U.S. dollars by multiplying that state's rent by the exchange rate.

Table 1 – Renting out your Condo for Case 1

State Probability Rent (Euro) Exchange Rate (S) Rent (P)
1 1/3 €1,800 $1/1.00 E $1,800
2 1/3 €2,000 $1.25/1.00 E $1.25/1.00 E
3 1/3 €2,200 $1.50/1.00 E $3,300

In this case, we calculate 800 for (β). Positive (β) shows that your cash rent varies with the fluctuating exchange rate, and there is a potential economic exposure.

A special factor to notice is that as the Euro appreciated, the rent in Dollars also increased. A forward contract for € 800 at a contract price of $1.25 per €1 can be bought to hedge against the exchange rate risk.

In Table 2, (β) is the correct hedge for Case 1. The Forward Price is the exchange rate in the forward contract and it is the spot exchange rate for a state.

Suppose we bought a forward contract with a price of $1.25 per euro.

  • If State 1 occurs, the Euro depreciates against the U.S. dollar. By exchanging € 800 into Dollars, we gain $200, and we compute it in the Yield column in Table 2.

  • If State 2 occurs, the forward rate equals the spot rate, so we neither gain nor lose anything.

  • State 3 shows that the Euro appreciated against the U.S. dollar, so we lose $200 on the forward contract. We know that each state is equally likely to occur, so we, on average, break even by purchasing the forward contract.

Table 2 – The Beta is the Correct Hedge for Case 1

State Forward Price Exchange rate Yield
1 $1.25/1 $1.00/1E (1.25 – 1.00) × 800 = 200$
2 $1.25/1E $1.25/1E (1.25 – 1.25) × 800 = 0
3 $1.25/1E $1.50/1E (1.25 – 1.50) × 800 = –200 $
Total $ 0

The rents have changed in Table 3. In Case 2, you could now get € 1,667.67, € 2,000, or € 2,500 per month in cash, and all rents are equally likely. Although your rent fluctuates greatly, the exchange moves in the opposite direction of the rent.

Table 3 – Renting out your Condo for Case 2

State Probability Rent (E) Exch. Rate Rent (P)
1 1/3 2,500 $1/1E $2,500
2 1/3 2,000 $1.25/1E $2,500
3 1/3 1,666.67 $1.50/1E $2,500

Now, do you notice that when you calculate the rent in dollars, the rent amounts become $2,500 in all cases, and (β) equals –1,666.66? A negative (β) indicates that the exchange rate fluctuations cancel the fluctuations in rent. Moreover, you do not need a forward contract because you do not have any economic exposure.

We finally examine the last case in Table 4. The same rent, € 2000, is charged for Case 3 without considering the exchange rate changes. As the rent is calculated in U.S. dollars, the exchange rate and the rent amount move in the same direction.

Table 4 – Renting out your Condo for Case 3

State Probability Rent (E) Exch. Rate Rent (P)
1 1/3 2,000 $1/1E $2,000
2 1/3 2,000 $1.25/1E $2,500
3 1/3 2,000 $1.50/1E $3,000

However, the (β) equals 0 in this case, as rents in Euros do not vary. So, now, it can be hedged against the exchange rate risk by buying a forward for €2000 and not the amount for the (β). By deciding to charge the same rent, you can use a forward to protect this amount.

Techniques to Reduce Economic Exposure

International firms can use five techniques to reduce their economic exposure −

  • Technique 1 − A company can reduce its manufacturing costs by taking its production facilities to low-cost countries. For example, the Honda Motor Company produces automobiles in factories located in many countries. If the Japanese Yen appreciates and raises Honda's production costs, Honda can shift its production to its other facilities, scattered across the world.

  • Technique 2 − A company can outsource its production or apply low-cost labor. Foxconn, a Taiwanese company, is the largest electronics company in the world, and it produces electronic devices for some of the world's largest corporations.

  • Technique 3 − A company can diversify its products and services and sell them to clients from around the world. For example, many U.S. corporations produce and market fast food, snack food, and sodas in many countries. The depreciating U.S. dollar reduces profits inside the United States, but their foreign operations offset this.

  • Technique 4 − A company can continually invest in research and development. Subsequently, it can offer innovative products at a higher price. For instance, Apple Inc. set the standard for high-quality smartphones. When dollar depreciates, it increases the price.

  • Technique 5 − A company can use derivatives and hedge against exchange rate changes. For example, Porsche completely manufactures its cars within the European Union and exports between 40% to 45% of its cars to the United States. Porsche financial managers hedged or shorted against the U.S. dollar when the U.S. dollar depreciated. Some analysts estimated that about 50% of Porsche's profits arose from hedging activities.

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