International Finance: Putting Theory Into Practice

498 CHAPTER 13. MEASURING EXPOSURE TO EXCHANGE RATES

Figure 13.2:How Convexity Arises in Operating Exposure

sell at

2000$

St

S

sell at

1900$

sell at

2100$

current sticky-

price zone

T

Cashflow

from exports

(DEM, cet.par.)

Key The lines show an exporter’shccash flows for a givenfcsales price, everything else being
constant. The optimal price depends on the exchange rate. A policy of always choosing the best
price leads to a convex relation betweenSand the expected cash flow.

abandoning exports would be an option: zero cash flows are better than negative
ones. In the case of a rising dollar, similarly,VWmight have considered lowering its
usdprice below 2,000, giving up some profit margin in exchange for more market
share. Again, this will be adopted if it beats the passive policy. The final picture is
one of a piecewise-linear, convex relation (Figure 13.2: passive sticky-prices policies
for exchange rates close to the current level, but switching to new and better policies
if the change has become sufficiently big.

In fact, in the above paragraph we have actually wandered from the realm of
contractual exposure into that of short-term operating exposure. Before we proceed
with this, let’s point out one major implication of the fact that the effect of exchange-
rate changes now is of a general non-linear form, E(V ̃T|ST) =ft,T(S ̃T), rather than
a contractual-exposure type relationV ̃T=Bt,TS ̃T. The implication is that exposure
is no longer some number offcunits that can be found in the balance sheet, or a
fccash flow as stated in a pro forma P&L. Rather, exposure has to be computed—
notably from a comparison of two or more possible outcomes for the firm at time
T, one outcome per possible exchange rate. As a colleague put it, “the idea is
completely foreign to accounting-tiedCFOs”. Here’s your chance to get ahead.

13.3 Measuring and Hedging of Operating Exposure

While contractual exposure focuses on the effect of the exchange rate on future
cash flows whose value in foreign currency terms is contractually fixed in the past,
operating exposure analyzes the impact of future exchange rates onnoncontractual
future cash flows. Thesefccash flows that are likely to be random even in terms