An unexpected change in exchange rates impacts a firm's expected cash flows at three levels, depending on the time horizon used (Short Run, Medium Run, and Long Run)

Question

Describe the three operating exposure's phases of adjustment assuming that parity conditions do not hold among foreign exchange rates, national inflation rates, and national interest rates (disequilibrium).
What will be an ideal response?

Answer 1

Answer: The first level impact is on expected cash flows in the one-year operating budget. The gain or loss depends on the currency of denomination of expected cash flows. These are both existing transaction exposures and anticipated exposures. The currency of denomination cannot be changed for existing obligations, or even for implied obligations such as purchase or sales commitments. In the short run it is difficult to change sales prices or renegotiate factor costs. Therefore, realized cash flows will differ from those expected in the budget.

The second level impact is on expected medium-run cash flows assuming disequilibrium conditions. In this case, the firm may not be able to adjust prices and costs to reflect the new competitive realities caused by a change in exchange rates. The primary problem may be the reactions of existing competitors. The firm's realized cash flows will differ from its expected cash flows. The firm's market value may change because of the unanticipated results.

The third level impact is on expected long-run cash flows, meaning those beyond five years. At this strategic level a firm's cash flows will be influenced by the reactions of both existing competitors and potential competitors-possible new entrants-to exchange rate changes under disequilibrium conditions. In fact, all firms that are subject to international competition, whether they are purely domestic or multinational, are exposed to foreign exchange operating exposure in the long run whenever foreign exchange markets are not continuously in equilibrium.