Question

Part A) What is the danger in an exporting business that chooses to hedge its exposure? Describe what constitutes success and failure, be specific about the HEDGE.

Part B) How are economic exposure and economies of scale related. Explain.

Answer 1

A. The risk associated with an exporting business is that the currency values might move in a way that causes a loss to the business. For e.g. suppose a US company is to receive Euros in 6 months. If the Euro depreciates in 6 months, the company will be at a loss. Hence, they need to hedge their position to protect themselves from this change in the value of Euros. Success and failure are meant by the relative movement in exchange rates. Because of the hedge it might happen that the rates move such that had the company not hedged their position, they would have benefitted. Therefore, hedge only works to fix the proceeds you are to receive. Though it protects you from the downside, it also eliminates the upside benefit available to you.

B. Economic exposure, also known as operating exposure refers to an effect caused on a company’s cash flows due to unexpected currency rate fluctuations. Economic exposures are long-term in nature and have a substantial impact on a company’s market value. Diversifying the production facilities and sales to a number of markets rather than concentrating on one or two markets would mitigate the risk inherent. However, in such cases, the companies have to forgo the advantage earned by economies of scale. Advantage due to economies of scale means that the company is producing the goods in bulk, so the per-unit cost of goods comes down as the fixed cost gets distributed across many units produced. Hence, if we are diversifying, we will be producing only some goods of each category and hence will be losing out on economies of scale.