Economic/Operating Exposure
Outline
• Lufthansa case
• Operating Exposure
– Example
– Measuring operating exposure
– Managing operating exposure
• financial hedges
• business strategies
Lufthansa
• Jan. ‘85: purchased 20 Boeing 737’s for
$500 mln, payable Jan. 1986.
• What to do with the DM/$ exchange risk?
–
–
–
–
–
Remain uncovered?
Hedge 100% forward?
Hedge some forward?
Put options?
Money market hedge/prepay?
Exhibit 1 (Lufthansa) Lufthansa’s
Net Cost by Hedging Alternative
Lufthansa
• Herr Rutnau felt the dollar was overvalued, and
was likely to depreciate, reducing DM cost of
aircraft.
• But he wasn’t sure. It could appreciate (had
done so for 5 years).
• Sold 50% forward.
Exhibit 2 (Lufthansa) What Herr
Ruhnau Could See: The Rise
Lufthansa
• Herr Rutnau felt the dollar was overvalued, and
was likely to depreciate, reducing DM cost of
aircraft.
• But he wasn’t sure. It could appreciate (had
done so for 5 years).
• Sold 50% forward.
• Outcome:
– Dollar did depreciate: down 28%!!
• Rutnau heavily criticized for selling forward.
Exhibit 3 (Lufthansa) What Herr
Ruhnau Couldn’t See: The Fall
Exhibit 1 (Lufthansa) Lufthansa’s
Net Cost by Hedging Alternative
Accusations against Ruhnau
• Chose wrong time to buy Boeing. Dollar at
1980’s high in Jan. 85.
• Hedging 50% when he expected the dollar to
fall. Should have left the whole exposure
unhedged.
• Using forwards instead of options.
• Buying Boeing at all. Should have bought
Airbus.
Should Ruhnau be fired?
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?
Year
1
2
3
SF
SF10 mln
SF10 mln
SF10 mln
forecast:
.50 $/SF
.50 $/SF
.50 $/SF ...
E[$ CF]
$5 mln
$5 mln
$5 mln
V
10%
Perpetuity formula: V = C / r
So V = $5 mln / .10 = $50 mln
...
...
...
Year
1
2
3
SF
SF10 mln
SF10 mln
SF10 mln
forecast:
.50 $/SF
.50 $/SF
.50 $/SF ...
E[$ CF]
$5 mln
$5 mln
$5 mln
$50 mln
10%
What if SF depreciates 2%, to .49 $/DM?
...
...
...
Year
1
2
3
...
SF
SF10 mln
SF10 mln
SF10 mln
forecast:
.49 $/SF
.49 $/SF
.49 $/SF ...
...
E[$ 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
SF
1
2
3
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, persistent
exchange rate changes upon local-currency
foreign 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 raterelated 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
DM/DOLLAR EXCHANGE RATE, 1974-97
3.5
3
Plaza
DM/$
2.5
2
Louvre
1.5
1
74
76
78
80
82
84
86
88
90
92
94
96
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
Financial Management of Operating Exposure
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
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 interest
liabilities
-SF9 mln
-SF9 mln
-SF9 mln
...
SF1 mln
SF1 mln
SF1 mln
...
Net SF revenues
...
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
Currency swap
1. U.S. firm issues $ debt
U.S. firm
$ liabilities
Currency swap
2. U.S. firm enters into a currency swap
U.S. firm
Pays SF
Receives $
$ liabilities
swap
dealer
Currency swap
$ revenues cover $ liabilities
U.S. firm
Pays SF
Receives $
$ liabilities
swap
dealer
Currency swap
Net effect: U.S. firm has effectively issued SF
debt to finance its foreign subsidiary
U.S. firm
Pays SF
Receives $
$ liabilities
swap
dealer
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
Examples
• Goodyear-Mexico
– 37% Mexico peso devaluation 12/94
– Previously sold tires in Mexico
– Became major exporter to U.S., Europe, South
America
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 Production Initiatives
–
–
–
–
Market selection
Product Strategy
Pricing Strategy
Promotional Strategy
–
–
–
–
Product sourcing
Input mix
Plant location
Raising productivity
Marketing Initiatives
• 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
• 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 $.
European countries advertised Alpine skiing
heavily in U.S.
Production Initiatives
• Changing Input Mix
– foreign outsourcing of component inputs
Example: Caterpillar. 50% of pistons are
foreign (Brazil)
• Shifting production among multiple
international plants
– Westinghouse: Plants in Canada, Spain, Britain
& Brazil.
– Toyota in 1994-6
• Creating new plants abroad
Example: Japanese, German car plants in U.S.
Production Initiatives
• Raising productivity
•
•
•
•
closing inefficient plants
automation
negotiating wage & benefit cutbacks
alternate production processes
Example: U.S. paper & pulp industries
(Brazilian competition)
Production and marketing initiatives have substantially
internationalized U.S. business over the last 15 years.
3.0
2.5
2.0
1.5
U.S. Direct Investment Abroad
($ trillion)
1.0
0.5
0.0
Foreign Direct Investment in U.S.
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