Chapter 12

Operating Exposure

The Goals of Chapter 12

• Define and study the attributes of operating exposure, which is the risk that the future levels of operating income and costs denominated in foreign currencies could be influenced by exchange rate changes

• Discuss the impact of the operating exposure on firms’ expected cash flows in different time horizons

• Illustrate the operating exposure by a case of the hypothetical firm, Trident Germany

• Discuss how to manage operating exposure

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Definition and Attributes of Operating Exposure

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Definition of Operating Exposure• Operating exposure, also called economic exposure,

competitive exposure, or strategic exposure, measures any change in the present value of a firm resulting from changes in future operating cash flows caused by any unexpected change in exchange rates

• Therefore, operating exposure analysis accesses the impact of changing exchange rates on a firm’s operations over the following years and on its competitive position vis-à-vis other firms

• The goal of operating exposure analysis is to identify possible strategic actions or operating techniques that the firm might adopt to enhance its market value for unexpected exchange rate changes

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Attributes of Operating Exposure

• Measuring the operating exposure of a firm requires forecasting and analyzing the firm’s future foreign exchange exposures together with the future foreign exchange exposures of all the firm’s competitors and potential competitors– The response to the exchange rate changes from competitors could

affect the relative competitiveness of market participants• Future exchange rate changes not only alter the domestic

currency value of the firm’s foreign currency cash flows, but also change the quantity of foreign currency cash flows– The change of the quantity of foreign currency cash flows may due

to the change of the competiveness of the firm in various market worldwide

– For transactions exposure, the quantity of foreign currency remains unchanged

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Attributes of Operating Exposure• From a broader perspective, operating exposure is not

just the sensitivity of a firm’s future cash flows to unexpected changes in foreign exchange rates, but also to other key macroeconomic variables– Taking a car producer for example, not only exchange rates but

also interest rates and various prices affect the competitiveness and thus future operating cash flows

• A depreciating domestic dollar will enhance the firm’s competitiveness and improve its cash flows worldwide

• A reduction in interest rates in foreign countries improves the firm’s cash flows due to increased demand for its cars

• A increase in product prices of competitors located in foreign countries will improve the firm’s cash flow

※Since exchange rates are highly associated with other macroeconomic variables, the combined effect of exchange rates and other macroeconomic variables should be considered

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Attributes of Operating Exposure• The cash flows of the MNE can be divided into

operating cash flows and financing cash flows• Operating cash flows arise from intercompany (between

unrelated companies) and intracompany (between parent company and subsidiaries) receivables and payables, rent and lease payments, royalty and license fees, and management fees

• Financing cash flows are payments for intercompany and intracompany loans (principal and interest) and stockholder equity (new equity investments and dividends)

• Intracompany cash flow possibilities are summarized in Exhibit 12.1

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Exhibit 12.1 Financial & Operating Cash Flows Between Parent & Subsidiary

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Attributes of Operating Exposure• Operating exposure is far more important for the

long-run health of a business than changes caused by transaction or accounting exposure

• Operating exposure is inevitably subjective, because it depends on the views to estimate future cash flow changes over an arbitrary time horizon

• Planning for operating exposure is a total management responsibility because it depends on the interaction of strategies in finance, marketing, purchasing, and production

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Attributes of Operating Exposure

• An expected change in foreign exchange rates is not included in the definition of operating exposure – This is because both the management and investors should have

factored this information into their evaluation of anticipated operating results and market value of the firm

• For the management, the forward rate can be used when preparing the operating budgets, rather than assume that the spot rate would remain unchanged

• From investors, if the foreign exchange market is efficient, information about expected changes in exchange rates should be already reflected in a firm’s market value

• Only unexpected changes in exchange rates should cause market value of a firm to change

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Impact of the Operating Exposure

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Impact of Operating Exposure• An unexpected change in exchange rates impacts a firm’s

expected cash flows at four levels, depending on different time horizons:– Short run (< 1 year)

• It is difficult to change sales prices or renegotiate factor costs• Since the quantity of realized foreign currency will not change

substantially, its value in domestic dollars will differ from those expected in the budget only due to different exchange rates

– Medium run (2-5 years): Equilibrium case• If parity conditions hold among exchange rates, national inflation

rates, and national interest rates, the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows

• For instance, if id – if = –4%, according to the international Fisher effect, the domestic currency will appreciate by 4%, the firm can increase product prices in foreign currency by 4% and thus will receive the same expected cash flows at the end of this year

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Impact of Operating Exposure• If equilibrium exists continuously and a firm is free to adjust its

prices and costs to maintain its expected competitive position in that industry, the firm’s operating exposure may be zero

• If the firm is unable to adjust operations to the new competitive environment, the firm would experience operating exposure

– Medium run (2-5 years): Disequilibrium case• Under disequilibrium condition, the firm may not be able to adjust

prices and costs in advance to reflect the new competitive realities caused by a change in exchange rates

• Thus the firm’s realized cash flows will differ from its expected cash flows, so the firm’s value today may change due to the unanticipated results in exchange rates

– Long run (> 5 years)• Since all firms have foreign exchange operating exposure, their

adjustments in prices and costs to reflect exchange rate changes will affect the relative competitiveness among them

• A firm’s cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes

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Operating Exposure: Trident Corporation

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Illustration of Operating Exposure: Trident Corporation• Trident corporation, is a hypothetical U.S.-based MNE

with headquarters in Los Angeles, and it has 100%-owned manufacturing, sales, and service subsidiaries in Hamburg, Germany

• Exhibit 12.2 on the next slide presents the dilemma facing Trident as a result of an unexpected change in the value of the euro, which is the currency of economic consequence for the German subsidiary

• More specifically, there is concern over how the subsidiaries revenues (prices and volumes in euro terms), costs (input costs in euro terms), and competitive landscape will change with a fall in the value of the euro

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Exhibit 12.2 Trident Corporation and Trident Germany

※ An unexpected depreciation or appreciation in the value of the euro alters both the competitiveness of the subsidiary and the financial results which are consolidated with the parent company

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Illustration of Operating Exposure: Trident Corporation• The basic information about Trident Germany

– It uses European material and labor to produce– Half of production is sold within Europe for euros, and half is

exported to non-European countries, but all sales are invoiced in euros

– Accounts receivable are equal to one-fourth of annual sales– Inventory is equal to 25% of annual direct costs– It can expand or contract production volume without any

significant change in per-unit direct costs or in overall general and administrative expenses

– Depreciation on plant and equipment is €600,000 per year– The corporate income tax in Germany is 34%– The cost of capital for Trident Germany is 20% (to calculate the

present value of the change of future operating cash flows)

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Illustration of Operating Exposure: Trident Corporation

• Operating exposure depends on whether an unexpected change in exchange rates causes unanticipated changes in sales volume, sales prices, or operating costs

• Possible actions adopted by Trident Germany if the exchange rate depreciates from $1.2/€ to $1.0/€:– Since competing imported products are now priced higher in

Europe zone and products of Trident Germnay are now cheaper in non-European countries,

• if Trident Germany maintains constant sales prices the sales volume will increase both domestically and internationally

• depending on the management’s opinion about the price elasticity of demand, Trident Germany might choose to raise product prices in euros. If the competitive position of Trident Germany can maintain the same, it is possible to have little influence on the market share of Trident Germany

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Illustration of Operating Exposure: Trident Corporation

– On the cost side, the increase of the price level in Germany might raise the cost of Trident Germany,

• because of more expensive imported raw material or components

• because labor is now demanding higher wages to compensate for inflation in Germany

– In practice, the favorable effect of a euro depreciation on comparative prices (appears in the shorter term) will not be immediately offset by higher domestic inflation (appears in the longer term)

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Illustration of Operating Exposure: Trident Corporation• Three possible scenarios on Trident Germany’s operating

exposure for the depreciation from $1.2/€ to $1.0/€– Case 1: no change in other variables– Case 2: increase in sales volume; other variables remain constant

• The sales price is kept constant in euro terms, because management of Trident Germany has not observed any change in local German operating costs or because it sees an opportunity to increase market share

– Case 3: increase in sales price; other variables remain constant• Assume that the euro sales price is raised from €12.8 to €15.36 per

unit to maintain the same U.S. dollar-equivalent price

• The expected cash flow statements of the three cases for the future 5 years are shown in Exhibit 12.3

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Exhibit 12.3

$3,418,200 – $640,000

$3,840,600 – $5,600,000

A double sales volume will require additional investment in accounts receivable and in inventory

The investment in inventory is still $2,400,000, because annual direct costs will not change

※ In fact, there are infinitely many combinations of volume, price, and cost following the depreciation. Here are just three examples to show how to measure the operating exposure

At the end of the fifth year (2015), the cash outflows for working capital should be recaptured

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Management of the Operating Exposure

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Strategic Management of Operating Exposure• The objective of operating exposure management is

to anticipate and neutralize the impact of unexpected changes in exchange rates on a firm’s future cash flows

• To meet this objective, management can diversify the firm’s operating and financing base– Diversifying operating base means diversifying sales,

location of production facilities, and raw material sources

– Diversifying the financing base means raising funds in more than one capital market and in more than one currency

※Once the international diversification is achieved, the firm can adopt different operating or financing strategies to manage the operating exposure

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Strategic Management of Operating Exposure

• If a firm’s operations are diversified internationally, management is prepositioned both to recognize disequilibrium when it occurs and to react competitively– That is, for MNEs, management can recognize disequilibrium by

comparing the data from subsidiaries in different countries

• Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies– Management might make marginal shifts in sourcing raw

materials, capacity of production, or the marketing effort in different markets to manage operating exposure

– E.g., the marketing effort can be strengthened in export markets where the firm faces more price competitive due to exchange rate changes

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Strategic Management of Operating Exposure• Even if management does not actively distort normal

operations when exchange rates change,– the variability of the MNE’s cash flows can be reduced by

international diversification of its production, sourcing, and sales because exchange rate changes are likely to increase the firm’s competitiveness in some markets while reducing it in others

• Due to the inability of diversifying operations internationally, domestic firms may be subject to the full impact of foreign exchange operating exposure and do not have the option to react in the same manner as an MNE

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Strategic Management of Operating Exposure

• If a firm’s financing sources are diversified, it will be prepositioned to take advantage of temporary deviations from the international Fisher effect– More specifically, if interest rate differentials do not equal

expected change in exchange rates, opportunities to lower a firm’s cost of capital will exist

– However, to switch financing sources, a firm must already be well-known in the international capital market

• Ch14 will demonstrate that diversifying sources of financing, regardless of the currency of denomination, can lower a firm’s cost of capital and increase its availability of capital– But this would not be an option for a domestic firm that has

limited its financing to one capital market

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Strategic Management of Operating Exposure

• International diversification not only is useful for foreign exchange risk management but also has potentially favorable impact on other risks as well– It could reduce the variability of future cash flows due to

domestic business cycles, provided that these are not perfectly correlated with international cycles

– It could diversify political risks of individual countries

– It could reduce portfolio risk in the context of the capital asset pricing model

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Proactive Management of Operating Exposure

• Operating exposure (as well as transaction exposure) can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

• The six most commonly employed proactive (前瞻性、預測性 ) policies are:1. Matching currency cash flows

2. Risk-sharing agreements

3. Back-to-back or parallel loans

4. Currency swaps

5. Leads and lags

6. Reinvoicing center

※The above policies are also called the operating hedge methods mentioned in Ch11

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Proactive Management of Operating Exposure

• Here an example is considered, in which a U.S. firm has continuing export sales to Canada

• In order to compete effectively in Canadian markets, the firm invoices all export sales in Canadian dollars

• This policy results in a continuing receipt of Canadian dollars month after month

• This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements, as discussed before

• If the firm does not want to actively manage the exposure with contractual financial instruments, can the firm seek out a continual use, an outflow, for its continual inflow of Canadian dollars?

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Proactive Management of Operating Exposure

1. Matching currency cash flows– First and the most common way is the use of the financial hedge

to offset an anticipated continuous operating exposure by acquiring part of the firm’s debt-capital in that currency (see Exhibit 12.4)

• This form of hedging is effective in eliminating currency risk when the exposed cash flow is relatively constant and predictable over time

– Another alternative would be for the U.S. firm to seek out potential suppliers of raw materials or components in Canada as a substitute for U.S. or other foreign firms

• If the receivable and payable cash flows were roughly the same in magnitude and timing, this strategy forms a natural hedge

– A third alternative for the company is to engage in currency switching, in which the U.S. firm would pay foreign suppliers (e.g., Mexican) with Canadian dollars

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Exhibit 12.4 Matching: Debt Financing as a Financial Hedge

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Proactive Management of Operating Exposure

2. Risk-sharing agreements– An alternate method for managing a long-term cash flow exposure

between firms is via risk sharing agreement– This is a contractual arrangement in which the buyer and seller agree

to “share” or split currency movement impacts on payments between them

– This agreement smoothes the impact of volatile and unpredictable exchange rate movements on both parties

– The example for Ford and Mazda• Ford imports automotive parts form Mazda, so swings in exchange rates

can benefit one party at the expense of the other• One risk-sharing solution is that if the EX rate on the payment date is

between ￥ 115/$ and ￥ 125/$, Ford pays at that EX rate, but if the EX rate falls outside this range on the payment date, Ford and Mazda will share the difference equally

• That is, for ￥ 110/$ ( ￥ 130/$), the effective exchange rate for Ford will be ￥ 112.5/$ ( ￥ 127.5/$)

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Proactive Management of Operating Exposure

3. Back-to-Back loans:– A back-to-back loan, also referred to as a parallel loan or credit

swap, occurs when two business firms in separate countries arrange to borrow each other’s currency for a specific period of time

– The structure of a typical back-to-back loan for parent-subsidiary cross-border financing is in Exhibit 12.5

– The default risk is minimized, because each loan can be viewed as the cash collateral in the event of default for the other loan

• A further agreement can provide to maintain principal parity, e.g., if ￡ dropped by 6% for as long as 30 days, the British parent firtmmight have to advance additional pounds to the Dutch subsidiary to bring the principal value of the two loans back to parity

– However, it is difficult for a firm to find a partner, termed a counterparty, for the desired currency amount and timing

– So, it causes the development of the currency swap

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Exhibit 12.5 Using a Back-to-Back Loan for Currency Hedging

※ At an agreed terminal date, both subsidiaries return the borrowed currencies ※ Thus, the back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

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Proactive Management of Operating Exposure

4. Currency Swaps (or Cross Currency Swap, CCS):– In a currency swap, a firm and a swap dealer or swap bank agree

to exchange an equivalent amount of two different currencies for a specified time period

– For a Japanese (American) corporation, it exports to the U.S. (Japan) and earns U.S. dollars (Japanese yen), the cross currency swap is illustrated in Exhibit 12.6

– Swap dealer arrange most swap on a blind basis, meaning that the initiating firm does not know its counterparty

– A currency swap is similar to a back-to-back loan except that it does not affect the capital structure in the balance sheet

• Accountants in the U.S. treat the currency swap as a foreign exchange transaction rather than as a debt and treat the obligation to pay back the principal at maturity as a forward exchange contract, which are entered into a firm’s footnotes rather than as balance sheet items

• Thus, there is no translation exposures for CCS

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Exhibit 12.6 Using a Cross Currency Swap to Hedge Currency Exposure

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※ Initially, Japanese corporation (U.S. corporation) pays yen principal (dollar principal) and receives dollar principal (yen principal) ※ During the contract period, Japanese firm can “pay dollars” and “receive yen” ※ At the end of the cross currency swap, they return the dollar and yen principal to each other

Proactive Management of Operating Exposure5. Leads and Lags: Retiming the transfer of funds

– Firms can reduce both operating and transaction exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies

• To lead (lag) is to pay or receive earlier (later)– A firm that holds the soft (hard) currency and has debts in hard

(soft) currency will lead (leg) by using the soft (hard) currency to pay the hard (soft) currency debts as soon (late) as possible

• Soft (hard) currency indicates the currency that is inclined to depreciate (appreciate)

– For receivables, on the contrary, firms tend to collect soft foreign currency receivables early and collect hard foreign currency receivables later

– Leading or lagging payments will change the cash position of one firm, with the reverse effect on the other firm

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Proactive Management of Operating Exposure

– Intercompany leads and lags is difficult to be achieved, because the time preference of one firm imposes the detriment of the other firm

– Intracompany leads and lags is more feasible as related companies presumably embrace a common set of goals for the consolidated group

– Because the use of leads and lags can both minimize foreign exchange exposure and shift the burden of financing, many governments impose restrictions on the allowed range

• E.g., the restriction of180-day lag on trade receivables: after 180 days, the receivables should be classified as noncollectable receivables

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Proactive Management of Operating Exposure

6. Reinvoicing centers: – A recivoicing center is a separate corporate subsidiary that

serves as a type of “middleman” among the parent company and all foreign subsidiaries

– Manufacturing subsidiaries sell goods to distribution subsidiaries by selling first to a reinvoicing center, which in turn resells to the distribution subsidiary, and all subsidiaries trade with the reinvoicing center with their domestic currencies (see Exhibit 12.7)

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Exhibit 12.7 Use of a Reinvoicing Center

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Proactive Management of Operating Exposure

– Benefits from the creation of a reinvoicing center:• Managing foreign exchange exposure centrally

– This center allows the management of all foreign exchange transaction exposure for intracompany sales to be located in one place

– Reinvoicing center can focus on developing a specialized expertise to hedge foreign exchange exposure

• Guaranteeing the exchange rate for future orders– The reinvoicing center can set local currency prices or costs in

advance such that subsidiaries can make bids for final customers in advance

– Manufacturing (sales) subsidiaries can focus on their manufacturing (marketing) activities and their performance is judged without distortion from exchange rate changes

• Managing intrasubsidiary cash flows, e.g., leads and lags of payment

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Proactive Management of Operating Exposure

– Disadvantages for a reinvoicing center:• Additional expense for a firm and high initial setup cost

– Due to one additional corporate unit created and the costs of personnel to operate the reinvoicing center, it will increase the expense for a firm

– In addition, the initial setup cost is high because all existing order-processing procedures must be reprogrammed

• To bring increased scrutiny by tax authorities– Since the reinvoicing center will have an impact on the tax status

and customs duties of all subsidiaries, it will attract more focus from tax authorities to ensure that it is not functioning as a tax haven

• A variety of professional costs will be incurred for tax and legal advice

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Proactive Management of Operating Exposure• Some MNEs now attempt to hedge their operating

exposure with contractual hedges• Merck and Eastman Kodak have undertaken long-

term currency option positions hedges designed to offset lost earnings from adverse exchange rate changes

• The possibilities to hedge the “unhedgeable” operating cash flows are dependent on two abilities:– The ability to predict the firm’s future cash flows

– The ability to predict the firm’s competitor’s responses to exchange rate changes

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Proactive Management of Operating Exposure

• Merck example– Merck, as a U.S.-based pharmaceutical exporter, is capable of

making the prediction of long-run revenues, because the product prices are often regulated by governments and relatively predictable

– The research-oriented feature lets it highly centralized for production, operation, and financing

– Due to the fact that operation or financing diversifications are difficult to achieve, Merck purchases long-term put options on foreign currencies versus the US$ as insurance against potential loss from exchange rate changes

– If a firm wishes to insure the net earnings from exchange rate-induced losses, the option position would be smaller than a position attempting to replace gross sales revenues, i.e., it is cheaper to hedge only for the net earnings

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