Assessing Exchange Rate Assessing Exchange Rate Risk: Part IIRisk: Part II

Exchange Rate Exchange Rate ExposureExposure

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.

Increasing competition and rising costs have lowered Blades’ profit margins

Blades could cut costs by importing lower cost components from Thailand

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

THB 2,870 per pair (THB 1 = $ .0257)

Should Blades import components from Thailand?

$75 Per Pair

THB 2,870 (.0257) = $73.75

$75 - $73.75

$75100 = 1.6%

At the current exchange rate, Blades could cut their costs by 1.6% by importing from Thailand (a savings of $90,000)!!

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)

ConstantsRandom Variable

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

*% bae

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)

=.8 + 0.80 * (inf) + error

(1 – 2.25) = -1.25

Mean = . 80

Std. Dev. = .02

Mean = .80

Std. Dev. = . 35

Mean = 0

Std. Dev. = 2.20

Forecast

Mean = -.2%

Std. Dev. = 2.25%

%25.2)20.2()25.1()35(.)02(. 2222 StdDev

Your 95% confidence interval for the (monthly) percentage change in the exchange rate is [-4.7% , 4.3% ]

% Change in e

($/THB)

Forecast (% Change)

Mean = -.2%

Std. Dev. = 2.25%

Assessing transaction exposure

Costs ($) = e ($/THB) * 72,000*2,870 THB

THB 2,870 per pair (THB 1 = $ .0257)

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

Costs ($) = e ($/THB) * 72,000*2,870 THB

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

THB 2,870 per pair (THB 1 = $ .0257)

Mean = $5,300,026

Std. Dev. = $119,250

THB 2,870 per pair (THB 1 = $ .0257)

Should Blades import components from Thailand?

$75 Per Pair

Mean = $5,300,026

Std. Dev. = $119,250

Mean = $5,400,000

Std. Dev. = $0

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

Forecast (% Change)

Mean = -.2%

Std. Dev. = 2.25%

Assessing transaction exposure

Net Cash Flows($) = e ($/THB) * ( 72,000*2,870 - 30,000*4,500)

Net Cash Flows($)

Mean = 71,640,000*.0257(1-.002)

= $1,837,465

Std. Dev. = .0225*71,640,000*.0257

= $41,342 (2.25%)

= e ($/THB) * ( 71,640,000THB)

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)

JPY 8,000 per pair (JPY 1 = $ .0093)

THB 2,870*.0257*36,000 = $2,655,324

JPY 8,000*.0093*36,000 = $2,678,400

$5,333,724

$2,678,400

$5,333,724

Forecast (% Change)

Mean = 0%

Std. Dev. = 2.25%

Forecast (% Change)

Mean = 0%

Std. Dev. = 3.50%

$2,655,324

$5,333,724= .49 = .51

CORR = -.65

Net Cash Flows

%4.1014.)65.)(035)(.0225)(.51)(.49(.2)035(.)51(.0225.49.

724,333,5$

2222

SD

Mean

Cash flow Situation…And the Currencies

are…Currency

exposure

Equal Inflows of Two Currencies Positively Correlated High

Equal Inflows of Two Currencies Uncorrelated Moderate

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 Moderate

Inflow in one currency/outflow in another Negatively Correlated 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

GBP 1 = $1.80

Forecast (% Change)

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

GBP 1 = $1.80

Forecast (% Change)

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

11.1190

703

d

dd Q

P

P

QElasticity of Demand refers to the responsiveness of demand to price changes (here, the price is the interest rate)

Q = 500 – 3P

# Roller Blades

P

190

70d

dd

d

dd Q

P

P

Q

PPQ

Q

P

Q

%

%1%

1.1%

Suppose that Blades agrees to sell roller blades to England for $125 apiece. (GBP 70)

Current

GBP 1 = $1.80

Forecast (% Change)

Mean = 0

SD = 2.0%

Revenues = Price ($) * Quantity

ConstantForecast (% Change)

Mean = 0

SD = 2.0%*Elasticity = 2.2%

Revenues = Price ($) * Quantity

ConstantForecast (% Change)

Mean = 0

SD = 2.0%*Elasticity = 2.2%

Revenues = e ($/L)* Price (L) * Quantity

Constant

Forecast (% Change)

Mean = 0

SD = 2.0

GBP Pricing (Transaction Exposure)

USD Pricing (Economic Exposure)

Changes in currency prices can have all kinds of economic impacts. A more general way to estimate economic exposure would be as follows:

ttt beaPCF

Percentage change in the exchange rate ($/F)

Percentage change in cash flows (measured in home currency)

Regression Results

Variable Coefficients Standard Error t Stat

Intercept .05 1.5 .03

% Change in Exchange Rate -3.35 .97 -3.45

Regression Statistics

R Squared .63

Standard Error 1.20

Observations 1,000

tt beaPCF

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

CompanyCompany CitigrouCitigroupp

GeneraGeneral l MotorsMotors

Wall Wall MartMart

Net Income Net Income (2004)(2004)

$17.04B$17.04B $3.8B$3.8B $9B$9B

Income Income Gains/Losses Gains/Losses due to currency due to currency changeschanges

$731M $731M (4.3%)(4.3%)

$929M $929M (24%)(24%)

$320M $320M (3.5%)(3.5%)