economic operating exposure

III.2 Economic/Operating Exposure

6F:130 International Finance

Prof. David S. Bates

Lecture #19

Outline

• Operating Exposure– Example– Measuring operating exposure– Managing operating exposure

• financial hedges

• business strategies

Operating exposure(a.k.a. economic, competitive or strategic exposure)

• The impact of unexpected exchange rate changes upon known and unknown but expected future cash flows of the firm, for indefinite future.

• Firm value = discounted expected future cash flows• Operating exposure therefore measures how firm value

changes with unexpected changes in exchange rates

Simple example

• U.S. firm expects 10 mln SF/year from exports to Switzerland, indefinitely.

• Long-term exchange rate forecast = current spot exchange rate

• Current rate: 2 SF/$ (.50 $/SF)

• Required rate of return: 10%/year

• What if the SF depreciates?

E[$ CF] $5 mln $5 mln $5 mln ...

V10%

Perpetuity formula: V = C / r

Year 1 2 3 ...

SF SF10 mln SF10 mln SF10 mln ...

forecast: .50 $/SF .50 $/SF .50 $/SF ...

So V = $5 mln / .10 = $50 mln

E[$ CF] $5 mln $5 mln $5 mln ...

10%

What if SF depreciates 2%, to .49 $/SF?

Year 1 2 3 ...

SF SF10 mln SF10 mln SF10 mln ...

forecast: .50 $/SF .50 $/SF .50 $/SF ...

$50 mln

E[$ CF]

V

10%

New exchange rate implies new X-rate forecasts

Year 1 2 3 ...

SF SF10 mln SF10 mln SF10 mln ...

forecast: .49 $/SF .49 $/SF .49 $/SF ...

E[$ CF] $4.9 mln $4.9 mln $4.9 mln ...

V

10%

and new projected dollar cash flows

Year 1 2 3 ...

SF SF10 mln SF10 mln SF10 mln ...

forecast: .49 $/SF .49 $/SF .49 $/SF ...

E[$ CF] $4.9 mln $4.9 mln $4.9 mln ...

$49 mln

10%

and reduces the value of the firm by $1 mln.

Year 1 2 3 ...

SF SF10 mln SF10 mln SF10 mln ...

forecast: .49 $/SF .49 $/SF .49 $/SF ...

Year 1 2 3 ...

SF SF10 mln SF10 mln SF10 mln ...

Operating exposure:$1 mln change in firm value for every 2% change in the current$/SF rate

Measuring operating exposure

• Requires a longer-term perspective: viewing the firm as an ongoing concern with price and cost competitiveness affected by exchange rate changes

• Requires an overall assessment of the industry:– Nationality of competitors & suppliers– firm’s degree of market power

Example: Volvo

• Structure:• Imports supplies from Germany

• produces in Sweden

• Sells in U.S.

• Major competition:• German cars (BMW, Mercedes, Audi)

• Most important risks• Swedish krona vs. DM (not especially vs. $)

• Swedish interest rates

• German producer prices

Measuring operating exposure

• Types of firms:• Price-taking firms• Price-setting firms with market power

Price-taking firms

1. Analyze impact of unexpected, persistentexchange rate changes upon local-currencyforeign market prices, for indefinite future– Who’s the competition?

2. Analyze impact on home-currency cash flows

3. Decide what to do about the exchange rate- related operating exposure.

Simple example, revisited• U.S. firm expects 10 mln SF/year from exports

to Switzerland, indefinitely.

• Assumptions:– Competing with Swiss firms.– SF price unaffected by $/SF fluctuations

• Consequently, $ revenues heavily affected by $/SF changes:

10% SF depreciation lowers discounted expected revenues 10%.

• SF appreciation has the opposite effect.

Example #2: U.S. chemical firm exporting to Canada

• Major competition: other U.S. firms.

• Chemical industry sets C$ prices based on U.S. $ costs.

• IF the Canadian dollar depreciates 10%:– C$ prices rise overall by 10%. – Reduction in total Canadian sales by 2%.– Local currency result: C$ revenues up 8%.

– U.S. $ revenues for this firm fall 2%.

• Operating exposure not severe.

Price-setting firms with (some) market power

• Some ability to raise local-currency prices in foreign markets to offset FX depreciation.

• How much ability?

Depends on the price elasticity of demand for that firm’s products.

Example: 1985-87 dollar depreciation of 50% against DM

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Louvre

DM/DOLLAR EXCHANGE RATE, 1974-97

DM

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Example: 1985-87 dollar depreciation of 50% against DM

• Mercedes, BMW:– Raise $ prices to (partly) maintain DM revenues?– Leave $ prices unchanged to maintain market

share/sales volume?

• Policy: – Raised $ prices 30-40%– Intense advertising campaign to differentiate

German cars.

Managing Operating Exposure

• Financial management – contractual hedges

• Strategic management– marketing initiatives– production initiatives

Financial Management of Operating Exposure

If have stable, predictable FC earnings, various contractual/financial hedges are feasible for the medium term (1-5 years)

• long-term forward contracts • local-currency debt (matching)

• currency swaps

• long-term put options

Examples• Merck (pharmaceuticals)

– R&D, production in U.S.– Sales in U.S., abroad

• Sales predictable (niche-market)

• Local-currency prices often regulated abroad

• Kodak (film)– Concerned w/ maintaining foreign market share

(against Fuji)

• Pioneer Hi-Bred– Has foreign subsidiaries

Long-term forward contracts

• Waterford Crystal– Costs in Irish punt– Revenues in U.S. dollars– Sold anticipated $ revenues forward out 2 years

• Difficult to hedge forward beyond 5 years

Financial Management of Operating Exposure

Financial Management of Operating Exposure

If have stable SF revenues

want to finance them with stable SF debt

so that only net SF revenues at risk.

Year 1 2 3 ...

SF revenues SF10 mln SF10 mln SF10 mln ...

SF interestliabilities -SF9 mln -SF9 mln -SF9 mln ...

Net SF revenues SF1 mln SF1 mln SF1 mln ...

Example: Swiss subsidiary of U.S. firm

• If well-established, can directly issue SF debt

• If new, use a currency swap– U.S. firm issues dollar debt– U.S. firm swaps that debt for SF debt with a swap

dealer

1. U.S. firm issues $ debt

U.S. firm

$ liabilities

Currency swap

2. U.S. firm enters into a currency swap

U.S. firm

$ liabilities

swapdealer

Pays SF

Receives $

Currency swap

$ revenues cover $ liabilities

U.S. firm

$ liabilities

swapdealer

Pays SF

Receives $

Currency swap

Currency swapNet effect: U.S. firm has effectively issued SFdebt to finance its foreign subsidiary (& hedge its SF revenues)

U.S. firm

$ liabilities

swapdealer

Pays SF

Receives $

Strategic Management of Operating Exposure

• In medium- to long-run, all firms have exchange rate-related operating exposure.

Example: “domestic” U.S. car company (Chrysler?)– Costs in U.S. dollars– Sales, revenues in U.S. dollars

• Yen depreciation makes Japanese cars more competitive, reducing Chrysler’s revenues

• Real exchange rate movements affect the overall competitive environment– monitoring/measuring such effects important– hedging can be difficult (and questionable)

• Firms respond strategically to exchange rate-related problems and opportunities– marketing initiatives– production initiatives

• Goodyear-Mexico– 37% Mexico peso devaluation 12/94 – Previously sold tires in Mexico– Became major exporter to U.S., Europe, South

America

Examples

Examples• U.S. textile industry

– U.S. cannot compete in labor-intensive textiles– Major investment in capital-intensive textiles

niches• Industrial fabrics

• Sheets, towels

– Increased service component• Quick Reponse computerized inventory

management and ordering program for coordinating textile mills/apparel manufacturers/retailers

Strategic Management of Operating Exposure

Marketing Initiatives– Market selection– Product Strategy– Pricing Strategy– Promotional Strategy

Production Initiatives– Product sourcing– Input mix– Plant location– Raising productivity

• Market selection & diversification– Move into/out of various foreign markets,

depending on competitiveness Example: Waterford Crystal (Irish) When $ weakened in late 1980’s, went

increasingly after Asian, European markets.

Marketing Initiatives

Marketing Initiatives• Product Strategy

– Altering product niche depending on competitiveness

• New-product introduction• Product line decisions• Product innovation

• Example: Volkswagen (1970’s)– 1960’s: low-priced cars with few features

– DM appreciation in early 1970’s, rising German labor costs

– VW revised product line towards higher-priced cars for middle-income consumers

Marketing Initiatives• Pricing Strategy

– For firms with some market power: decision between

• market share

• profit margins

when setting local-currency prices following a currency appreciation/depreciation.

• Promotional Strategy Example: Early 1980’s: strong $. European countries advertised Alpine skiing

heavily in U.S.

Production Initiatives• Changing Input Mix

– foreign outsourcing of component inputs Example: Caterpillar. 50% of pistons are foreign

(Brazil)

• Shifting production among multiple international plants– Westinghouse: Plants in Canada, Spain, Britain

& Brazil. – Toyota in 1994-6

• Creating new plants abroad Example: Japanese, German car plants in U.S.

Production Initiatives• Raising productivity

• closing inefficient plants

• automation

• negotiating wage & benefit cutbacks

• alternate production processes

Example: U.S. paper & pulp industries(Brazilian competition)

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85 87 89 91 93 95 97 99 01 03 05

U.S. Direct Investment Abroad($ trillion)

Foreign Direct Investment in U.S.

Production and marketing initiatives have substantially internationalized U.S. business over the last 20 years.

Summary• Unexpected exchange rate fluctuations generally

affect the short-term and longer-term prospects of the firm -- operating exposure

• There exist some financial tools for managing identifiable operating exposure

• currency swaps, ...

• Firms typically respond strategically to exchange rate-related shifts or potential shifts in relative competitiveness

• Marketing initiatives• Production initiatives