Professional Documents
Culture Documents
Why Hedge?
As we have seen, exposure alone does not justify hedging. However, the risk associated with a particular exposure may be sufficient to justify hedging. But this assumes that companies are risk-averse. When are companies risk-averse? This question must be addressed before a firm undertakes the costs associated with hedging foreign exchange risks. Why do corporations prefer a known home currency amount rather than a gamble with the same expected value involving potential gains or losses? What is the ultimate objective of the firm? To maximize shareholder valueand minimize systematic 4 risks.
Why Hedge?
Relative to the amount of hedging that takes place, the arguments for firm risk-aversion are somewhat scarce. When will risk management improve shareholder wealth and/or reduce their systematic risk? 1. Tax gain/loss treatment asymmetry. 2. High financial distress costs. 3. Internal vs. external capital markets. 4. Executive compensation / monitoring / transparency. 5. Firms can hedge more efficiently than their shareholders. The point is that unless a firm can identify one of the above concerns as relevant to a particular exposure, the costs associated with hedging may not be worthwhile.
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Marketing Management
Marketing management focuses on increasing sales in countries in which the real exchange rate has appreciated and restructuring sales in countries where the real exchange rate has declined. Marketing management has three main dimensions: 1. Promotional strategy. If the marginal cost of promoting a product does not rise as much as the marginal benefit in response to an appreciation, it will make sense to shift promotional resources from undervalued currencies towards overvalued currencies.
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Marketing Management
2. Product design and development. Although new products will generally be introduced based on long-run competitive merits calculated at the long run real exchange rate, the optimal time to introduce new products may be when the exchange rate is high. When revenues are relatively high in home currency terms, it may be easier to justify high market entry costs particularly if these costs are partially determined in the home currency. Effectively, having a new product to introduce to a market is like owning a long-dated call option. When the currency becomes sufficiently appreciated, the option should be exercised - the product should be introduced.
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Marketing Management
3. Pricing strategy. If firms have some flexibility to adjust prices and pass-through the exchange rate effects, they may want to take advantage of this in responding to exchange rate changes. Specifically, firms selling in overvalued currencies will want to lower the local currency price to capture larger market share, while those operating in undervalued currencies will raise prices to maintain profit margins. Certainly firms in more competitive industries face less flexibility in terms of their pricing schedules.
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Production Management
Just as marketing activities focus on firms that are overvalued, production activities will focus on countries where currencies are undervalued. Certainly a firm will face less flexibility on the production side than on the sales side. Nonetheless, to the extent possible, a firm has a number of potential production responses to shifts in exchange rates: 1. Since the costs of labor-intensive production activities are most likely to fluctuate with real exchange rate changes, they should be shifted from overvalued to undervalued currencies. In this way, having a flexibility with respect to production sourcing acts as a portfolio of currency options which benefit from exchange rate variability. 18
Production Management
2. Similarly, input components can be sourced from countries with depreciated exchange rates at the expense of countries with high exchange rates. This activity is essentially enforcing the law of one price for traded goods, and as such, opportunities may be limited. 3. While expansions of capacity, introductions of new technology, and other efforts to improve productivity should be based on long-run comparative advantage and real exchange rates, again, the optimal time to introduce such changes may be when the currency is depreciated. The investment can be easily justified since its costs are likely to be lower and the facility is already realizing a 19 comparative advantage and operating at high volume.
Production Management
Similar to new product introduction, opportunities to expand capacity or introduce new production technologies behave as a put option on the currency. The option should be exercised when the currency is depreciated and costs are low. Generally, production management will require a high degree of flexibility from the outset. Since this flexibility will generally take the form of excess capacity, it must come at some cost. Nonetheless, the option-like nature of this flexibility adds value to the firm from both risk management and profit maximization standpoints.
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