Economic Exposure

Economic Exposure :

How much will the value of the firm - as measured by the present value of its expected future cash flows -change when exchange rates change?

I. Foreign Exchange Risk & Economic Exposure

Assume we can buy tequila for US$6 and Mexican peso MXN 84, with a rate of MXN peso 14/$

If inflation was 4% in Mexico, and 8% in the US, what would be the price after one year to maintain relatively equal price?

US Mexico

$6 * (1 + .08) = $6.48 MXN 84 (1+.04) = MXN 87.36

New exchange rate to maintain equilibrium 87.36/6.48, or MXN peso13.4815/$

While the rate has changed, the relative buying power is still the same between the two currencies. The dollar has lost value, but the inflated dollar at the lower exchange rate will still by the same bottle of tequila:

$6.48 * MPeso 13.4815/$ = MPeso 87.36

Another way to write this is with our old formula:

Et = E0 * (1 + i home )/ (1 + i reference)

MPeso 13.4815 = MPeso14 (1 + .04) / (1 + .08)

With this analysis, we can reexamine a nominal change in exchange rates incorporating inflation, with real changes that vary from changes related to inflation.

Another example: Danish krone (Dkr) depreciated by 5% while inflation was 3% in Denmark and 2% in the US.

Nominal exchange rate = E0 *(1.03) / (1.02)

If the Real exchange rate has depreciated 5%, then we need to multiply the nominal rate * .95

Real Exchange Rate = Nominal Exchange Rate (1 - .05) x (1.03/1.02)

= Nominal Exchange Rate (.9593)

Question : Who benefits from a 5% real decline in the Dkr?

Who is hurt by this move?

A. Inflation and Exchange Risk

Apex Philippines, Exchange Rates, and Inflation

Exhibit 11.2

B. Competitive Effects of Real Exchange Rate Changes

* ¥240/$ in 1985 and ¥90/$ in 1995, but change not compensated by additional inflation in the US; Yen became very expensive over 10 year period in real terms.

* Toyota screams at the Bank of Japan

* "An increase in the real value of a currency acts as a tax on exports and a subsidy on imports"

* Or exports become more expensive to overseas buyers, while foreign goods become cheaper