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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 firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide.

• 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.

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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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Financial & Operating Cash Flows Between Parent & Subsidiary

Subsidiary

Financial Cash Flows

Operational Cash Flows

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

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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 accounting exposure.

• 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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Measuring the Impact of Operating ExposureA. Short Run (1Year)

B. Medium Run: Equilibrium Case (2 to 5 Years)

Assume Parity Conditions Hold (FX, I, i)

• The firm should be able to adjust prices and factor costs over time.

• If equilibrium exists continuously, the operating exposure may be zero.

C. Medium Run: Disequilibrium Case

Realized cash flows will differ from expected cash flow the firm’s market value may change.

D. Long Run (> 5 Years)

All firms subject to international competition are exposed to long run operating exposure.

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• The following slide presents the dilemma facingCarlton, Inc. as a result of an unexpected change in the value of the euro, the currency of economicconsequence for the German subsidiary.

• There is concern over how the subsidiaries revenues (price and volumes in euro terms), costs (input costsin euro terms), and competitive landscape will change with a fall in the value of the euro.

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Measuring the Impact of Operating Exposure

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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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• Carlton Germany:- 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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Measuring the Impact of Operating Exposure

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Exhibit 12.3 Trident Europe

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Exhibit 12.3 Trident Europe

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Managing Operating Exposure

1. The Strategic Level Through Diversification A. Diversifying Operations:

• Diversifying sales, location of production facilities and raw material sources to reduce the variability of cash flows

B. Diversifying Financing:

• Take advantage of temporary deviations from the international fisher effect (FX, id - if )

• Lower the cost of capital by switching financing sourcesC. Constraints:

• Some industries require large economies of scale; limit the diversifying production locations

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2. Changing Operating Policies

Adopting operating policies that deviate from normal domestic-oriented policies.

A. Using Leads and Lags

• To Lead: Use soft currency to pay hard currency debt early

• To Lag: Is to pay soft currency debt lateB. Risk Sharing

• Buyer and seller agree to split currency movement impacts on payments.

C. Reinvoicing Center

• Manages, in one location, all transaction exposures from intracompany trade

• Leads and Lags: Retiming the transfer of funds

- Firms can reduce both operating and transaction exposures 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. 14

Changing Operating Policies

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• 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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Changing Operating Policies

• Reinvoicing Centers: There are three basic benefits arising from the creation of a reinvoicing center:

- Managing foreign exchange exposure in one

place

- Guaranteeing the exchange rate for future orders

- Managing intrasubsidiary cash flows

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Changing Operating Policies

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Changing Operating Policies

3. Changing Financing Policies

A. Natural Hedging:

Matching currency cash flows

• Acquire debt denominated in the same currency

• Seek out potential suppliers in foreign country

B. Back-to-Back Loans:

Two firms in separate countries arrange to borrow each other’s currency for a specific period of time.

At terminal date, they return the borrowed currencies

• Difficult to find a counterparty 18

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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 othercontractual agreements. 19

Changing Financing Policies

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Changing Financing PoliciesCanadian

Corporation(buyer of goods) Exports

goods toCanada

CanadianBank

(loans funds)

US Corp borrowsCanadian dollar debtfrom Canadian Bank

Payment for goodsin Canadian dollars

Principal and interestpayments on debtin Canadian dollars

U.S.Corporation

Exposure: The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollars

Hedge: The Canadian dollar debt payments act as a financialhedge by requiring debt service, an outflow of Canadian dollars

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• 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 foreignsuppliers with Canadian dollars.

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Changing Financing Policies

• 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

other’s 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 ownbooks, borrows the same currency it repays. 22

Changing Financing Policies

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Changing Financing Policies1. British firm wishes to invest funds

in its Dutch subsidiary2. British firm identifies a Dutch firm wishing

to invest funds in its British subsidiary

British parentfirm

Dutch parentfirm

IndirectFinancing

Direct loanin pounds

Direct loanin euros

Dutch firm’sBritish subsidiary

British firm’sDutch subsidiary

3. British firm loans British poundsdirectly to the Dutch firm’s Britishsubsidiary

4. British firm’s Dutch subsidiary loanseuros to the Dutch parent

The back-to-back loan provides a method for parent-subsidiary cross-border financingwithout incurring direct currency 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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Changing Financing Policies

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C. Currency Swap (Off-Balance Sheet)

Two parties agree to exchange a given amount of one currency for another and, after a period of time, to give back the original amounts swapped.

Requires two firms to borrow funds in the markets and currencies in which they are best known.

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Both the Japanese corporation and the U.S. corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt.

JapaneseCorporation

United StatesCorporation

Assets Liabilities & Equity Assets Liabilities & Equity

Inflow

of US$

Receive yen

Payyen

ReceivedollarsSwap Dealer

Wishes to enter into a swap to“pay yen” and “receive dollars”

Wishes to enter into a swap to“pay dollars” and “receive yen”

Sales to US Debt in yen Sales to Japan Debt in US$

Paydollars

Inflow

of yen