Managing Economic/ Operating Exposure

1
Managing Economic/ Operating Exposure

• International Corporate Finance
• P.V. Viswanath
• For use with Alan Shapiro Multinational
  Financial Management

2
Learning Objectives

• To define economic exposure and exchange risk and
  distinguish between the two
• To identify the basic factors that determine the
  forex risk faced by a particular company or
  project.
• To calculate economic exposure given a particular
  exchange rate change and cost/revenue scenarios
• To describe marketing, production financial
  strategies appropriate for coping w/ econ
  exposure.
• Contingency plans to cope with forex risk.

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Operating Exposure

• Operating Exposure is the firms uncertainty with
  respect to its future operating cash flows.
• If PV present value of a firm, then the firm is
  exposed to currency risk if ?PV/?e ? 0.
• Operating exposure derives from the operating
  analysis hence planning for operating exposure
  involves the interaction of strategies in
  finance, marketing, purchasing and production.

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Real Exchange Rates and Exposure

• Currency changes are usually preceded
  by/accompanied by changes in relative price
  levels, which can offset the impact of the
  currency change.
• Hence, it is impossible to determine exposure to
  a given currency change without considering
  simultaneously the offsetting effects of these
  price changes.
• If relative prices remain constant and the law of
  one price holds, then the rate of change in the
  exchange rate equals the difference in inflation
  rates between the two countries. That is, the
  real exchange rate is constant, and PPP holds.
• The firms foreign cash flows will vary with the
  foreign rate of inflation.
• The exchange rate also depends on the
  differential rates of inflation the movement of
  the exchange rate will cancel out the effect of
  the change in the foreign price level. Real
  dollar cashflows will be unaffected.

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Contracts fixed in foreign currency

• If the firm has contracts fixed in foreign
  currency terms, it will be affected by exchange
  rate risk even if relative prices are unaffected
  and PPP holds.
• Examples are debt with fixed interest rates,
  long-term leases, labor contracts and rent.
• However, if real exchange rates do not change,
  what we see here is really inflation risk and not
  forex risk. That is, the same effect can occur
  domestically, as well.
• If contracts are indexed and if the real exchange
  rate remains constant, forex risk is eliminated.

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Effects of Real Exchange Rate Changes

• A decline in the real value of a nations
  currency makes its exports and import-competing
  products more competitive.
• E.g. if Brazils inflation rate stays high, but
  its exchange rate stays constant, the real
  exchange rate will be rising and its products
  will be at a competitive disadvantage.
• Hence there could be exchange risk even without
  changes in nominal rates.
• An increase in the real value of a currency acts
  as a tax on imports and a subsidy for exports.
• If the domestic production cost of a product
  rises, but exchange rates remain the same, its
  cost in foreign currency will rise and it will be
  disadvantaged relative to producers in other
  countries whose costs have not gone up. Hence
  the correlation between domestic production costs
  and exchange rates is important.

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Real Exchange Rate Changes
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Operating Exposure

• In evaluating the impact of an exchange rate
  change on the firm, we cannot assume that local
  currency cost and revenue streams remain
  constant.
• Measuring the likely exchange gain (loss) by
  multiplying the pre-devaluation (pre-revaluation)
  local currency cashflows by the projected
  devaluation (revaluation) will usually lead to
  upwardly biased numbers.
• This is partly because inflation and exchange
  rate changes are related, as shown by PPP.
• Also, the firm itself, its competitors and
  customers have flexibility in terms of the
  decisions that they make.

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Pricing Flexibility

• The key issue for a domestic firm, when the
  dollar appreciates is its pricing flexibility.
• Can it maintain its dollar margins both at home
  and abroad?
• Can it maintain its dollar price on domestic
  sales in the face of lower-priced foreign
  imports?
• In the case of foreign sales, can the firm raise
  its foreign currency selling price to preserve
  its dollar profit margin?

10
Price Elasticity of Demand

• The less price elastic the demand for the
  companys products, the more price flexibility
  the company has.
• Price elasticity depends on the degree of
  competition and the location of key competitors.
• The more differentiated a companys products are,
  the less competition it will face. (e.g. Mercedes
  Benz cars)
• If most competitors are based in the home
  country, then all will face the same change in
  their cost structure, and no one producer will be
  at a disadvantage vis-à-vis any other domestic
  producer.
• Commodity exporters are very vulnerable to real
  exchange effects because of the
  non-differentiated nature of their products.

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More about Flexibility

• The firms susceptibility to exchange rate risk
  depends also on its ability to shift production
  and the sourcing of inputs among countries.
• A foreign subsidiary selling goods in its local
  market cannot increase local prices enough to
  make up for a local currency devaluation.
  However,
• the devaluation will also help in fending off
  import competition.
• the dollar value of local production costs will
  drop however, the higher the import content of
  local inputs, the less dollar production costs
  will decline.
• if the firm can substitute local inputs for
  imported inputs, it can cope better with the
  devaluation.
• if the firm can sell in other markets, it can
  keep dollar revenues high.

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Explaining Exhibit 11.5

• Let the home country of the MNC be A, B is the
  country where the goods are produced, either for
  local sales in B or for export to C (or A
  itself). (Re)Devaluation occurs in country B.
• Row 1 (Revenue/Export Sales) refers to production
  in B for sale in C. If Bs currency is devalued,
  the good can be sold at a cheaper price in C and
  this will increase revenue in terms of As
  currency.
• Row 2 (Revenue/Local Sales) if there is weak
  prior import competition, then local prices will
  not be affected and hence the revenue in terms of
  As currency will drop.
• Row 4 (Costs/Domestic inputs) if import content
  is low, then dollar denominated costs are going
  to drop, since costs are constant in terms of Bs
  currency.

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What affects Exchange Rate Risk?
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Operating and Financing Cash Flows

• Operating Cash flows arise from receivables and
  payables, rent and lease payments for the use of
  facilities and equipment, royalty and license
  fees for the use of technology and intellectual
  property and assorted management fees for
  services provided.
• Financing Cash flows are payments for the use of
  loans (principal and interest), and stockholder
  equity (new equity investments and dividends).

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Intracompany MNE Operating and Financing Cash
Flows
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Operating Exposure

• Expected foreign exchange rate changes are not
  relevant for the definition of operating exposure
  because management and investors should have
  already factored this information into their
  evaluation of anticipated operating results and
  market value.
• For example, the forward rate might be used as a
  the future spot rate estimate in preparing
  operating budgets.
• Similarly, expected cash flow to amortize debt
  should already reflect the international Fisher
  effect. The level of expected interest and
  principal payments should be a function of
  expected exchange rates, rather than existing
  rates.

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Factors Affecting Operating Exposure An Example

• Operating exposure is not restricted to foreign
  exchange exposure.
• Example Volvos operating exposure can be traced
  to
• Swedish Krona/DM Exchange Rate uncertainty
• The uncertainty of future Swedish Krona
  short-term interest rates (which is related to
  the demand for cars).
• German producer price uncertainty
• Still, exchange rate uncertainty is very
  important and is characteristic of the operating
  exposure of global firms.

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Operating Exposure Short Run Impact

• The first level impact is on the one-year
  operating budget the gain or less depends on the
  currency of denomination of expected cash flows
• In the short run, it is difficult to change the
  exposure due to implied obligations, such as
  purchase or sales commitments, because the
  currency of denomination cannot be changed.
• It is also difficult to change sales prices or to
  renegotiate factor costs

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Operating Exposure Medium Run Parity Conditions
Hold

• The second level impact is on expected
  medium-term cash flows.
• If parity conditions hold, the firm should be
  able to adjust prices and factor costs over time
  to maintain the expected level of cash flows, if
  no real variables have changed.
• The country of cash flow origination and its
  monetary, fiscal, and balance of payments
  policies will determine whether firms can adjust
  prices and costs.
• Example If Volvo is selling cars to Germany and
  the DM depreciates because the German money
  supply rises, Volvo will be protected if it can
  raise its DM prices, so that the Krona price is
  maintained.

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Operating Exposure Medium Run Change in Real
Variables

• If the firm is not able to adjust prices and
  costs because the change in exchange rates has
  been accompanied by real changes, so that
  relative prices have been altered.
• Example If the DM has depreciated relative to
  the Krona because German investors have lost
  confidence in the German economy and are moving
  their capital to Sweden, the wealth of German
  investors has dropped, the real price of a
  Swedish car has risen and Volvo may not be able
  to raise its prices proportionately. There is
  less than perfect pass-through.

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Operating Exposure Long Run

• Long-run cash flows beyond five years could be
  affected. Cash flows will be influenced by the
  reactions of existing and potential competitors
  to exchange rate changes when real variables are
  affected.
• In principle, all firms subject to international
  competition, domestic or multinational, are
  subject to foreign exchange operating exposure in
  the long run, whenever real variables are
  affected.

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Instruments du Rhone 1
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Instruments du Rhone -- 2
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Managing Operating Exposure Strategically
Diversifying Operations

• The key to operating exposure management is to
  anticipate and influence the effect of unexpected
  changes in exchange rates on a firms future cash
  flows.
• Management can diversify the firms operating and
  financing base.
• Diversifying operations means diversifying sales,
  location of production facilities and raw
  material sources.
• Diversifying financing means raising funds in
  more than one capital market and in more than one
  currency.
• It can change the firms operating and financing
  policies.

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Strategic Diversification of Operations

• There might be a change in comparative costs in
  the firms own plants located in different
  countries.
• Management can make marginal shifts in sourcing
  raw materials, components, or finished products.
  If spare capacity exists, production runs can be
  lengthened in one country and reduced in another.
• There might be a change in profit margins or
  sales volume in one area compared to another,
  depending on price and income elasticities of
  demand and competitors reactions.
• Marketing efforts can be strengthened in export
  markets where the firms products have become
  more price-competitive.

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Managing Operating Exposure Diversifying
Financing

• Interest rates differentials might not adjust
  fully to expected changes in interest rates.
• In this case, provided the firm is established
  and known in different markets, it can change the
  source of its short and long-term financing.
• Diversifying financing per se can also help
  diversify risks of restrictive capital market
  policies or government borrowing competition in
  the capital market
• It can help diversify political risks
  expropriation, war, blocked funds, or unfavorable
  changes in laws.

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Changing Operating Policies Leads and Lags

• Firms can reduce transaction and operating risk
  by accelerating (lead) or decelerating (lag) the
  timing of payments. This will depend on expected
  changes in exchange rates.
• Firms can also try to accelerate or decelerate
  the collection of receivables, for the same
  reason, and in the same way.
• Suppliers/Clients may not want to go along. This
  may require incentive payments.

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Intracompany Leads and Lags

• Leading and lagging between related firms is more
  feasible.
• When done between subsidiaries, it has the effect
  of an intracompany loan and represents an
  alternative way of shifting capital, that is less
  subject to government interference.
• However, it is unfair if each unit has minority
  stockholders separate from the corporate family,
  since leading/lagging will affect the relative
  rate of return of the different units.
• Widespread leading/lagging can affect exchange
  rates. Hence, governments that want to affect
  exchange rates may put limits on lagging.

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Intracompany leads and lags

• Suppose a multinational company faces the
  following after-tax borrowing and lending rates
• Borrowing Rate Lending Rate
• US 3.8 2.9
• Germany 3.6 2.7
• If the US unit requires funds and the German unit
  has excess funds, then leading funds owed by the
  German unit to the US unit or lagging funds owed
  by the US unit to the German unit has the effect
  of a loan by the German unit to the US unit with
  a saving of 110 basis points.
• If both units have excess funds, it would be
  profitable to move funds to the US, with an
  interest differential of 20 basis points (2.9
  versus 2.7).

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Risk Sharing

• Risk-Sharing is a contractual arrangement in
  which the buyer and seller agree to share or
  split currency movement impacts on payments that
  pass between them.
• This is worthwhile if the relationship between
  the two firms is long-term.
• For example, Ford and Mazda may agree that all
  purchases by Ford will be made in Japanese yen at
  the current rate, as long as it is between 115
  and 125 yen/.
• If the rate falls outside this range, they may
  agree to share the difference equally.
• Of course, if the equilibrium rate level changes
  drastically, the agreement will have to be
  changed.

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Reinvoicing Centers

• A reinvoicing center is a separate corporate
  subsidiary that manages in one location all
  transaction exposure from intracompany trade.
• Effectively, the reinvoicing center centralizes
  transaction exposure risk, and diversifies the
  exposure of the parent company to transaction
  exposure. It need only hedge residual exposure
  risk.
• This method releases individual company
  subsidiaries from having to worry about
  transaction exposure for intracompany trades.
• The reinvoicing center can manage intra-affiliate
  cash flows, including leads and lags of payments.

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Reinvoicing Centers
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Modifying Financing Policies Natural Hedges

• One way to offset an anticipate continuous long
  exposure to a particular currency is to acquire
  debt denominated in that currency.
• If stable (in foreign currency) and continuing
  receipts from sales are expected, debt in the
  foreign currency could be issued the sales
  receipts would be used to make interest payments
  on the debt. This is a form of matching.
• The firm could also seek raw material suppliers
  in Canada, so that sales receipts could be used
  to pay for purchases.
• The firm could arrange to pay raw material
  suppliers from a third country using the foreign
  currency of the sales receipts.

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Natural Hedges An Example
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Back to Back Loans

• Also known as a parallel loan or credit swap.
• Two firms in separate countries agree to borrow
  each others currency for a specified period of
  time. At an agreed terminal date, they return
  the borrowed currencies.
• Principal parity might be required akin to
  marking to market.
• The advantage is that there is no foreign
  exchange risk, and it doesnt require the
  approval of any government body regulating the
  use of foreign exchange.
• However, a counterparty must be found for the
  currency, amount and timing desired.

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Back to Back Loans
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Currency Swaps
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Currency Swaps

• Accountants in the US treat currency swaps as
  foreign exchange transactions rather than as debt
  and treat the obligation to reverse the swap at
  some later date as a forward exchange contract.
• Forward exchange contracts can be matched against
  assets, but they are entered in a firms
  footnotes rather than as balance sheet items.
  Hence, both accounting and operating exposures
  are avoided.

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Contractual Hedging and Long-term Exposure

• Normally, firms take contractual positions like
  forward contracts and options in order to hedge
  positions that do not have quantity risk (but
  only exchange rate risk), such as hedging
  transaction exposure.
• However, firms that have relatively predictable
  cash flows might use contractual strategies to
  hedge operating exposure as well. This is
  usually difficult because it is necessary for the
  firm to be able to predict competitor response as
  well.
• Another question with contractual hedging to
  protect against changes in strategic position is
  that it is purely a short-term hedge. A change
  in strategic posture would be a longer-term
  response.
• Hence contractual hedging would be effective only
  if the strategic impacts are temporary.