Operating Exposure

Operating Exposure

• Operating exposure, also called economic exposure, competitive exposure, and even strategic exposure

• It measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates.

Operating Exposure

• Operating exposure depends upon– Change in nominal exchange rate – Change in the selling price (output

price) – Change in the quantity of output sold – Change in operating costs i.e.

quantities and prices of inputs

Operating Exposure

• Operating exposure can be looked upon as a combination of two effects - the conversion effect and the competitive effect – Conversion effect refers to the changes in

home currency value of a given foreign currency cash flow

– Competitive effect refers to changes in foreign currency cash flows.

Attributes of Operating Exposure

• Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide.

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 its sensitivity to other key macroeconomic variables.

• This factor has been labeled macroeconomic uncertainty.

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 units of the same company) receivables and payables, rent and lease payments, royalty and license fees and assorted management fees.

Attributes of Operating Exposure

• Financing cash flows are payments for loans (principal and interest), equity injections and dividends of an inter and intracompany nature

Financial & Operating Cash Flows Between Parent & Subsidiary

Financial Cash Flows

Operational Cash Flows

Subsidiary

Payment for goods & servicesRent and lease paymentsRoyalties and license fees

Management fees & distributed overhead

Dividend paid to parentParent invested equity capitalInterest on intrafirm lendingIntrafirm principal payments

Parent

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 estimates of future cash flow changes over an arbitrary time horizon.

Attributes of Operating Exposure

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

Attributes of Operating Exposure

• An expected change in foreign exchange rates is not included in the definition of operating exposure, because both management and investors should have factored this information into their evaluation of anticipated operating results and market value.

Attributes of Operating Exposure

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

• Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change.

Measuring the Impact of Operating Exposure

• An unexpected change in exchange rates impacts a firm’s expected cash flows at four levels, depending on the time horizon used:– Short run

– Medium run: Equilibrium case

– Medium run: Disequilibrium case

– Long run

Assessing Operating Exposure: Scenario Approach

• Consider alternative exchange rate scenarios and under each specify how prices, quantities and costs will behave

• Based on considerations of competitive behaviour and the response of the various cost components to domestic and foreign inflation and changes in exchange estimate operating cashflows under different scenarios

• Assess likelihood of different scenarios

Assessing Operating Exposure: Scenario Approach

• The firm needs to know the structure of its output markets, demand elasticities and competitive reactions as well as detailed information about its cost structure and the response of the various cost components to changes in exchange rate and other macroeconomic shocks

• Simultaneous changes in several variables complicates the task further since precise identification of the impact of each becomes difficult

An Exporter Firm

• Real depreciation will increase the profitability - measured in home as well as foreign currency - of an exporter provided again that relative price shifts are not significantly adverse

• This would be generally true unless the costs rise faster than inflation at home.

An Importer Firm

• A real depreciation of the home currency will reduce importer's profits measured in either currency

• The case of a firm which imports raw materials and components for further processing at home and sells the output in the home market is more difficult since the effect of a real depreciation on profit depends upon the share of imported inputs in total costs, the elasticity of demand and the behavior of other costs

Currency of Invoicing, Quantity Criteria and Operating Exposure

• In practice, a substantial amount of trade involves contractual arrangements between the exporter and the importer wherein both the quantities supplied and prices - in either party's currency - are fixed for sometime

• While prices respond to exchange rate changes rather quickly, quantity response to price changes is likely to be considerably slower

Currency of Invoicing, Quantity Criteria and Operating Exposure

• If the importer does not have easy access to forward markets or if bid-ask spreads in forward markets are very large, an exporter insisting on invoicing in his own currency will face a competitive disadvantage if other exporters who are willing to accommodate the importer by invoicing in the latter's currency

Currency of Invoicing, Quantity Criteria and Operating Exposure

• Invoicing preferences would depend upon the strength of the currency of invoicing, competitive factors, invoicing practices of competitors etc. Exporters in weak currency countries would prefer to invoice in FC; their importers might prefer to be invoiced in exporter’s currency. Trading off operating and transactions exposure

Coping with Operating Exposure

• None of the financial instruments used to reduce transactions exposure are of much use in reducing operating exposure

• To the extent the firm can correctly identify and estimate its operating exposure to exchange rates, it can in principle use forward contracts to hedge

• The difficulty is in identifying and estimating the exposure coefficients

• Operating exposure covers a much longer horizon that contractual transactions exposures

• Too many uncertainties

Coping with Operating Exposure

• Operating exposure must be managed by altering the firm's operations - pricing, choice of markets, sourcing, location of production etc.– The firm can reduce the adverse effects of

exchange rate changes on its revenue by moving into product lines which are less price sensitive and by countering the effect of higher prices by means of other competitive weapons such as local advertising and promotion

–

Coping with Operating Exposure

• If inputs are purchased in markets where the local content in their costs is high, exchange rate changes will significantly alter the relative costs of sourcing from alternative sources

Coping with Operating Exposure

– Shifting the location of production to countries whose currencies have depreciated in real terms can reduce the adverse impact of exchange rate changes provided production costs in different locations have a large local content

• Reasons for the globalization of production and sourcing may in fact be the desire on the part of MNCs to match the currencies of revenues and costs

Coping with Operating Exposure

• When output markets are not perfectly competitive, the strategy of currency matching of costs and revenues might result in smaller expected profits though it will reduce the variance of profits

The Practice of Exposure Management

• The key findings of investigations of corporate currency exposure management practices – Very few corporations undertake an accurate,

quantitative assessment of how unanticipated exchange rate changes impact on the value of their firm

– Most firms find it very difficult to gauge the long-term exposure of their businesses to currency fluctuations

The Practice of Exposure Management

– Relatively more but still a minority of the firms have some reliable quantitative understanding of the exposure of their operating cash flows to currency fluctuations

– A surprisingly large number of firms appear to think that they are not exposed to currency risk or that the risk is trivial

The Practice of Exposure Management

– Even among firms which engage in systematic assessment of their currency risk profile and conscious currency risk management, the focus is almost exclusively on short-term transactions exposures extending up to a year

The Practice of Exposure Management

– Long-term operating exposures are dealt with by "on-balance sheet" operating mechanisms

• Firms also react to exchange rate changes after-the-fact by revising pricing policies, wage contracts etc.

• Thus the practice of currency risk management, particularly long term exposure, is much less precise and sophisticated than what the development of the theory would suggest

Measuring the Impact of Operating Exposure

• The following slide presents the dilemma facing Bharti Instruments as a result of an unexpected change in the value of the euro, the currency of economic consequence for the German subsidiary.

• There is concern over how the subsidiaries revenues (price 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.

Strategic Management of Operating Exposure

• The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows, rather than merely hoping for the best.

• To meet this objective, management can diversify the firm’s operating and financing base.

• Management can also change the firm’s operating and financing policies.

• A diversification strategy does not require management to predict disequilibrium, only to recognize it when it occurs.

Strategic Management of Operating Exposure

• Operations to be are diversified internationally

• Financing sources to be diversified