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Chapter 11. Operating Exposure. Operating Exposure: Learning Objectives. Examine how operating exposure arises through the unexpected changes in both operating and financing cash flows

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Chapter 11

Chapter 11

Operating Exposure


Operating exposure learning objectives
Operating Exposure: Learning Objectives

Examine how operating exposure arises through the unexpected changes in both operating and financing cash flows

Analyze the sequence of how unexpected exchange rate changes alter the economic performance of a business unit though the sequence of volume, price, cost and other key variable changes

Evaluate strategic alternatives to managing operating exposure

Detail the proactive policies firms use in managing operating exposure


Operating exposure
Operating Exposure

Measuring the operating exposure (AKA economic exposure, competitive exposure, or strategic exposure) of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposure of all the firm’s competitors and potential competitors

This long term view is the objective of operating exposure analysis


Trident corporation a multinational s operating exposure
Trident Corporation: A Multinational's Operating Exposure

As a U.S.-based publicly traded company, ultimately all financial metrics and values have to be consolidated and expressed in U.S. dollars. (See Exhibit 11.1)

Net operating = Receivables over time - Payables over time

cash flow from sales for inputs and labor



Trident corporation a multinational s operating exposure1
Trident Corporation: A Multinational's Operating Exposure

Operating cash flows arise from intercompany and intracompany receivables and payables, rent and lease payments, royalty and licensing fees, and other associated fees

Financing cash flows are payments for the use of inter and intracompany loans and stockholder equity



Expected versus unexpected changes in cash flows
Expected Versus Unexpected Parent and SubsidiaryChanges in Cash Flows

Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

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

An expected change in exchange rates is not included in the definition of operating exposure because management and investors should have factored this into their analysis of anticipated operating results and market value


Trident s operating exposure
Trident’s Operating Exposure Parent and Subsidiary

Trident derives much of its reported profits from its German subsidiary and there has been an unexpected change in the value of the euro thus affecting Trident significantly

Trident’s German subsidiary is operating in a euro-denominated competitive environment

The subsidiary’s profitability and performance will be impacted by any changes in performance and pricing from its suppliers and customers as a result of changes in the US$/euro exchange rate


Measuring operating exposure
Measuring Operating Exposure Parent and Subsidiary

Short Run - The first-level impact is on expected cash flows in the 1-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

Medium Run Equilibrium - The second-level impact is on expected medium-run cash flows, such as those expressed in 2- to 5-year budgets


Measuring operating exposure1
Measuring Operating Exposure Parent and Subsidiary

Medium Run: Disequilibrium. The third-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

Long Run. The fourth-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 and potential competitors, possible new entrants, to exchange rate changes under disequilibrium conditions




Strategic management of operating exposure
Strategic Management of Operating Exposure and Response

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

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


Diversifying operations
Diversifying Operations and Response

Diversifying operations means diversifying the firm’s sales, location of production facilities, and raw material sources

If a firm is diversified, management is prepositioned to both recognize disequilibrium when it occurs and react competitively

Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies


Diversifying financing
Diversifying Financing and Response

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

If a firm is diversified, management is prepositioned to take advantage of temporary deviations from the International Fisher effect


Proactive management of operating exposure
Proactive Management of Operating Exposure and Response

Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated currency exposures

Six of the most commonly employed proactive policies are

Matching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

Leads and lags

Reinvoicing centers


Matching currency cash flows
Matching Currency Cash Flows and Response

One way to offset an anticipated continuous long exposure to a particular currency is to acquire debt denominated in that currency

This policy results in a continuous receipt of payment and a continuous outflow in the same currency

This can sometimes occur through the conduct of regular operations and is referred to as a natural hedge




Currency clauses risk sharing
Currency Clauses: Risk-sharing Euro Depreciation

Risk-sharing is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments

Example: Ford purchases from Mazda in Japanese yen at the current spot rate as long as the spot rate is between ¥115/$ and ¥125/$.

If the spot rate falls outside of this range, Ford and Mazda will share the difference equally

If on the date of invoice, the spot rate is ¥110/$, then Mazda would agree to accept a total payment which would result from the difference of ¥115/$- ¥110/$ (i.e. ¥5)


Currency clauses risk sharing1
Currency Clauses: Risk-sharing Euro Depreciation

Ford’s payment to Mazda would therefore be

Note that this movement is in Ford’s favor, however if the yen depreciated to ¥130/$ Mazda would be the beneficiary of the risk-sharing agreement


Back to back loans
Back-to-Back Loans Euro Depreciation

A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two firms in different countries arrange to borrow each other’s currency for a specific period of time

The operation is conducted outside the FOREX markets, although spot quotes may be used

This swap creates a covered hedge against exchange loss, since each company, on its own books, borrows the same currency it repays


Cross currency swaps
Cross-Currency Swaps Euro Depreciation

Cross-Currency swaps resemble back-to-back loans except that it does not appear on a firm’s balance sheet

In a currency swap, a dealer and a firm agree to exchange an equivalent amount of two different currencies for a specified period of time

Currency swaps can be negotiated for a wide range of maturities

A typical currency swap requires two firms to borrow funds in the markets and currencies in which they are best known or get the best rates


Cross currency swaps1
Cross-Currency Swaps Euro Depreciation

For example, a Japanese firm exporting to the US wanted to construct a matching cash flow swap, it would need US dollar denominated debt

But if the costs were too great, then it could seek out a US firm who exports to Japan and wanted to construct the same swap

The US firm would borrow in dollars and the Japanese firm would borrow in yen

The swap-dealer would then construct the swap so that the US firm would end up “paying yen” and “receiving dollars” be “paying dollars” and “receiving yen”

This is also called a cross-currency swap



Contractual approaches
Contractual Approaches Euro Depreciation

Some MNEs now attempt to hedge their operating exposure with contractual strategies

These firms have undertaken long-term currency option positions hedges designed to offset lost earnings from adverse changes in exchange rates

The ability to hedge the “unhedgeable” is dependent upon predictability

Predictability of the firm’s future cash flows

Predictability of the firm’s competitor responses to exchange rate changes

Few in practice feel capable of accurately predicting competitor response, yet some firms employ this strategy


Summary of learning objectives
Summary of Learning Objectives Euro Depreciation

Foreign exchange exposure is a measure of the potential for a firm’s profitability, cash flow, and market value to change because of a change in exchange rates. The three main types of foreign exchange risk are operating, transaction, and translation exposures.

Operating exposure measures the change in value of the firm that results from changes in future operating cash flows caused by an unexpected change in exchange rates

Operating strategies for the management of operating exposures emphasize the structuring of firm operations in order to create matching streams of cash flows by currency: this is termed matching


Summary of learning objectives1
Summary of Learning Objectives Euro Depreciation

An unexpected change in exchange rates impacts a firm’s expected cash flow at four levels: 1) short run; 2) medium run, equilibrium case; 3) medium run, disequilibrium case; and 4) long run.

Operating strategies for the management of operating exposure emphasize the structuring of firm operations in order to create matching streams of cash flows by currency.This is termed natural hedging.

The objective of operating exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows, rather than being forced into passive reaction


Summary of learning objectives2
Summary of Learning Objectives Euro Depreciation

Proactive policies include matching currency of cash flow, currency risk sharing clauses, back-to-back loans, and cross currency swaps

Contractual approaches have occasionally been used to hedge operating exposure but are costly and possibly ineffectual

Strategies to change financing policies include matching currency cash flows, back-to-back loans and currency swaps


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