������������������MEASUREMENT AND MANAGEMENT OF OPERATING EXPOSURE

INTRODUCTION

Measurement of Operating Exposure

• Real exchange rate changes and exchange risk
• Inflation and exchange risk
• Price and quantity changes of exchange rate changes
• Operational measure of exchange risk

Measurement of Operating Exposure

1. Real exchange rate changes and exchange risk
1. The exchange rate changes that give rise to operating exposure are real exchange rate changes.
2. The real exchange rate is defined as nominal exchange rate (No. of domestic currency units per unit of foreign currency) adjusted for changes in the relative purchasing power of each currency since some base period.

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e’t=et *(1+ift)/(1+iht)

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Where, e’t= real exchange rate at time t

et= nominal exchange rate at time t

ift=the amount of foreign inflation between times 0 and t

iht=the amount of domestic inflation between times 0 and t

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Given that the base period nominal rate, e0 is also the real base period echange rate, the change in the real exchange rate can be calculated as follows:

e’t-e0/e0

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For example suppose that the USD has devalued by 5% during a year. At the same time, US and Indian inflation rates are 3% and 2% respectively, then the real exchange rate is :

et’ = 0.95eo*1.03/1.02

= 0.96e0

Applying the formula, 0.96e0-e0/e0=-4%

• A dramatic change in the nominal exchange rate accompanied by equal change in prices should have no effects on relative competitive position of domestic firms and their foreign competitors and will not alter real cash flows
• Alternatively, if the real exchange rate changes, it will cause relative price changes i.e changes in the ratio of domestic goods prices to prices of foreign goods
• So in terms of currency changes, focus must not be on nominal exchange rate changes, but instead on changes in the purchasing power of one currency relative to another.

2) Inflation and Exchange Risk

• Constant relative prices and looking at the effects of only inflation means that if the inflation rate is 10% then the price of every good in the economy

rises by 10%.

• If the law of one price prevails then the rate of change in exchange rate must equal the difference between inflation rate between two countries and leads towards PPP.
• Without relative price changes, an MNC does not face any real operating exposure.
• In other words when there is change in only nominal exchange rate with no change in real exchange rate then cash flows will not be affected.

Example: A Ltd., the US subsidiary of an Indian company sells devices in US. Current rate is 1$= Rs. 70. Cost of devices =$1,000and if he selling price is $ 3,000 then the profit margin is $2,000. Suppose US inflation during the year is 20% and there is no inflation in India

Then according to PPP

e1= e0*(1+ih)/(1+if)= 70*(1+0)/ (1+.2)= 58.33

Applying real exchange rate formula

et’= e1*(1+if)/(1+ih)= 58.33*(1+0.2)/ (1+0)= 70

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3) Price and Quantity Effects of Exchange Rate Changes

• Geographical extent of the market
• Dominant producers and consumers of goods
• Impact on input prices

4) Operational Measures of Exchange Risk

• Simulation approach
• Regression approach

Management of Operating Exposure

The management of operating exposure involves taking key decisions pertaining to following areas:

• Marketing Management
• Market selection
• Pricing policies
• Promotional Strategies
• Product Strategy

Management of Operating Exposure

• Production Management
• Diversify cross border operations
• Inputs sources diversified
• Plant location
• Financial Mnagement