Chapter 12

Operating Exposure

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Operating Exposure
Operating exposure, also called economic exposure, competitive exposure, and even strategic exposure on occasion, 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.

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Attributes of Operating Exposure

Measuring the operating exposure of a firm requires forecasting and analyzing all the firms future individual transaction exposures together with the future exposures of all the firms competitors and potential competitors worldwide. The analysis of longer term where exchange rate changes are unpredictable and therefore unexpected is the goal of operating exposure analysis.
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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 units of the same company) receivables and payables, rent and lease payments, royalty and license fees and assorted management fees. Financing cash flows are payments for loans (principal and interest), equity injections and dividends of an inter and intracompany nature
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Exhibit 12.1 Financial and Operating Cash Flows Between Parent and 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 translation exposure. However, operating exposure is inevitably subjective because it depends on estimates of 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, because both management and investors should have factored this information into their evaluation of anticipated operating results and market value. From an investors perspective, if the foreign exchange market is efficient, information about expected changes in exchange rates should be reflected in a firms market value. Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change.

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Measuring the Impact of Operating Exposure

The following slide presents the dilemma facing Trident 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.
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Exhibit 12.2 Trident Corporation and Its European Subsidiary: Operating Exposure of the Parent and Its Subsidiary

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Measuring the Impact of Operating Exposure

Trident Europe:
Case 1: Devaluation, no change in any variable. Case 2: Increase in sales volume; other variables remain constant. Case 3: Increase in sales price; other variables remain constant.

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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 firms future cash flows, rather than merely hoping for the best. To meet this objective, management can diversify the firms operating and financing base. Management can also change the firms operating and financing policies. A diversification strategy does not require management to predict disequilibrium, only to recognize it when it occurs.

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Strategic Management of Operating Exposure

If a firms operations are diversified internationally, management is prepositioned both to recognize disequilibrium when it occurs and to react competitively. Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies. 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 firms financing sources are diversified, it will be prepositioned to take advantage of temporary deviations from the international Fisher effect. However, to switch financing sources a firm must already be well-known in the international investment community. Again, this would not be an option for a domestic firm (if it has limited its financing to one capital market).
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Proactive Management of Operating Exposure

Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures. The six 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 center
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Copyright 2010 Pearson Prentice Hall. All rights reserved.

Proactive Management of Operating Exposure

In this example, a US 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.

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Exhibit 12.4 Matching: Debt Financing as a Financial Hedge

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Proactive Management of Operating Exposure

Matching currency cash flows.
One way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching). Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms. In addition, the company could engage in currency switching, in which the company would pay foreign suppliers with Canadian dollars.
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Proactive Management of Operating Exposure

Currency Clauses: Risk-Sharing:
An alternate method for managing a long-term cash flow exposure between firms is risk sharing.
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 is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements.

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Proactive Management of Operating Exposure

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 others currency for a specific period of time.
At an agreed terminal date they return the borrowed currencies. Such a swap creates a covered hedge against exchange loss, since each company, on its own books, borrows the same currency it repays.
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Exhibit 12.5 Using a Back-to-Back Loan for Currency Hedging

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Proactive Management of Operating Exposure

There are two fundamental impediments to widespread use of the back-to-back loan:
It is difficult for a firm to find a partner, termed a counterparty for the currency amount and timing desired. A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity although each party has 100% collateral (denominated in a different currency).

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Proactive Management of Operating Exposure

Currency Swaps:
A currency swap resembles a back-to-back loan except that it does not appear on a firms balance sheet. 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 amount of time.

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Exhibit 12.6 Using a Cross-Currency Swap to Hedge Currency Exposure

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Proactive Management of Operating Exposure

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. Intracompany leads and lags is more feasible as related companies presumably embrace a common set of goals for the consolidated group. Intercompany leads and lags requires the time preference of one independent firm to be imposed on another.

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Proactive Management of Operating Exposure

Reinvoicing Centers: There are three basic benefits arising from the creation of a reinvoicing center:
Managing foreign exchange exposure Guaranteeing the exchange rate for future orders Managing intrasubsidiary cash flows

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Exhibit 12.7 Use of a Reinvoicing Center

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

The ability to hedge the unhedgeable is dependent upon:

Predictability of the firms future cash flows Predictability of the firms competitors responses to exchange rate changes

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Mini-Case Questions: Toyotas European Operating Exposure

Why do you think Toyota waited so long to move much of its manufacturing for European sales to Europe? If Britain were to join the European Monetary Union, would the problem be resolved? How likely do you think it is that Britain will join? If you were Mr. Shuhei, how would you categorize your problems and solutions? What was a short-term and what was a long-term problem? What measures would you recommend Toyota Europe take to resolve the continuing operating losses?

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Chapter 12

Additional Chapter Exhibits

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Exhibit 12.3 Trident Europe

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Exhibit 1 Toyota Motors European Currency Operating Structure

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Exhibit 2 Daily Exchange Rates: Japanese Yen per Euro

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Exhibit 3 Daily Exchange Rates: British Pounds per Euro

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