Operating exposure- the extent to which the firm’s operating cash flows would be affected by random changes in exchange rates.  Operating exposure cannot be determined from accounting statements as transaction exposure. Explain the competitive and conversion effects of exchange rate changes on the firm’s operating cash flow. Competitive effect: how depreciation/appreciation affect operating cash flow by altering the firm’s competitive position in the marketplace.  This depends on the market structure of inputs and products: how competitive or monopolistic the markets facing the firm are.  Conversion effect: how depreciation/appreciation changes the operating cash flow by the firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes.

Due to the hyperinflation crisis in Zimbabwe, there was an extreme depreciation in the value of the Zimbabwe dollar. Zimbabwe’s rate of inflation reached 79.6 Billion %! In effect, Zimbabwe grain, like many other Zimbabwe imports suffered significantly.  So, the exposure to grain companies had two components:

1. Competitive effect: difficulties and an increased costs for importing and selling grain

2. Conversion effect: lower dollar prices of imports due to foreign currency  exchange rate depreciation

8) What are the advantages and disadvantages to a firm of financial hedging of its operating exposure compared to operational hedges (such as relocating its manufacturing site)

Operational hedges

a. Selecting low-cost production sites

– Setting up in an area with relatively weak currency.  Giving you cheaper labor and production costs

b. Flexible sourcing policy

– Choosing to source operations from countries where input costs are low.

c. Diversification of the market

– Economies all around the world change all the time.  If you place your entire product line in one country, a lull in the economy can lead to huge decreases in the demand for your product.  This is much more unlikely if you place your product all around the world.

d. R&D efforts and product differentiation

– Positive R&D efforts can cut costs and lead to new, innovative product ideas

These options are certainly valuable and are frequently utilized by firms all around the world.  However, many times these options (which involve redeployment of resources) can become costly and impractical.  This is when financial hedging is a much better option.

Financial hedging

This is used to stabilize the firm’s cash flows by investing in currency forwards or options (also by lending and borrowing).  This will eliminate a large portion of the exchange rate risk.  However, since investing in these derivatives only takes in account the nominal value and not the real value (which is what you are interested in), financial hedging can only provide an approximate hedge against the firms operating exposure. Advantages and disadvantages of maintaining multiple manufacturing sites as a hedge against exchange rate exposure. Advantages include business stability from less exposure to exchange rate volatility, production flexibility to maximize low-cost benefits of currency depreciation, and global presence, which may catalyze market diversification (another hedge). Disadvantages include increased risk (political, social etc.) and increased production costs (inability to realize economies of scale). Unable to predict currency fluctuations long-term (currencies moving in an unintended manner)


1. Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pounds will be worth $1.40. If the British economy slows down, on the other hand, the land will be worthless, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability.

(a) Estimate your exposure b to the exchange risk.

Solution: (a)

E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580

E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44

Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2

= .00096+.00144 = .0024.

Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44)

= -5.28-7.92 = -13.20

b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.

Exposure netting-hedging based on net exposure, no one hedges gross exposure. Exposure to assets and operating cash flow. Operating exposure having an impact on operating cash flow based on exchange rates impacted on net income level. Determinants of operating exposure

Managing operating exposure-r and d, 5 items

Financial hedging is listed as something to be done for economic exposure, short-term in nature and is not effective as other items

Statistical perspective

Euro and foreign bonds characteristics-don’t need to know tax rules

Euro medium notes

Currency Distribution, nationality and blah skip

International bond ratings



Clearing procedures-skip

International Bond Market Index

Market Capitalization in developing countries vs.  others

Concentration very liquid and very diversified in mature, less concentrated and liquid in developing

Market structure, cost, and trading practices

Market Consolidation

Trading in International Equities

Yankee stock offerings

American Depository Receipts

International equity benchmarks


Factors affecting international equity

Leave a Reply

Your email address will not be published. Required fields are marked *