Chapter 10

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Chapter 11
Operating
Exposure
Operating Exposure: Learning
Objectives
• Examine how operating exposure arises through
the unexpected changes in both operating and
financing cash flows
• Analyze the sequence of how unexpected exchange
rate changes alter the economic performance of a
business unit though the sequence of volume,
price, cost and other key variable changes
• Evaluate strategic alternatives to managing
operating exposure
• Detail the proactive policies firms use in managing
operating exposure
11-2
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Operating Exposure
• Measuring the operating exposure (AKA economic
exposure, competitive exposure, or strategic exposure)
of a firm requires forecasting and analyzing all the
firm’s future individual transaction exposures together
with the future exposure of all the firm’s competitors
and potential competitors
• This long term view is the objective of operating
exposure analysis
11-3
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Trident Corporation: A
Multinational's Operating Exposure
• As a U.S.-based publicly traded company, ultimately all
financial metrics and values have to be consolidated and
expressed in U.S. dollars. (See Exhibit 11.1)
Net operating = Receivables over time - Payables over time
cash flow
from sales
for inputs and labor
11-4
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Exhibit 11.1 Trident Corporation:
Structure & Operations
11-5
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Trident Corporation: A Multinational's
Operating Exposure
• Operating cash flows arise from intercompany
and intracompany receivables and payables, rent
and lease payments, royalty and licensing fees,
and other associated fees
• Financing cash flows are payments for the use
of inter and intracompany loans and stockholder
equity
11-6
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Exhibit 11.2 Financial and Operating Cash
Flows Between Parent and Subsidiary
11-7
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Expected Versus Unexpected
Changes in Cash Flows
• Operating exposure is far more important for the
long-run health of a business than changes caused
by transaction or translation exposure
– Planning for operating exposure is total management
responsibility since it depends on the interaction of
strategies in finance, marketing, purchasing, and
production
– An expected change in exchange rates is not included in
the definition of operating exposure because
management and investors should have factored this into
their analysis of anticipated operating results and market
value
11-8
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Trident’s Operating Exposure
• Trident derives much of its reported profits from
its German subsidiary and there has been an
unexpected change in the value of the euro thus
affecting Trident significantly
• Trident’s German subsidiary is operating in a eurodenominated competitive environment
– The subsidiary’s profitability and performance will be
impacted by any changes in performance and pricing
from its suppliers and customers as a result of changes in
the US$/euro exchange rate
11-9
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Measuring Operating Exposure
• Short Run - The first-level impact is on expected cash flows
in the 1-year operating budget. The gain or loss depends on
the currency of denomination of expected cash flows.These
are both existing transaction exposures and anticipated
exposures. The currency of denomination cannot be changed
for existing obligations
• Medium Run Equilibrium - The second-level impact is on
expected medium-run cash flows, such as those expressed in
2- to 5-year budgets
11-10
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Measuring Operating Exposure
• Medium Run: Disequilibrium. The third-level impact is on
expected medium-run cash flows assuming disequilibrium
conditions. In this case, the firm may not be able to adjust
prices and costs to reflect the new competitive realities
caused by a change in exchange rates
• Long Run. The fourth-level impact is on expected long-run
cash flows, meaning those beyond five years. At this
strategic level, a firm’s cash flows will be influenced by the
reactions of both existing and potential competitors, possible
new entrants, to exchange rate changes under disequilibrium
conditions
11-11
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Exhibit 11.3 Operating Exposure’s
Phases of Adjustment and Response
11-12
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Exhibit 11.4 Trident & Trident
Germany
11-13
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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 firm’s future cash flows
• To meet this objective, management can diversify
the firm’s operating and financing base
• Management can also change the firm’s operating
and financing policies
11-14
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Diversifying Operations
• Diversifying operations means diversifying the
firm’s sales, location of production facilities, and
raw material sources
• If a firm is diversified, management is
prepositioned to both recognize disequilibrium
when it occurs and react competitively
• Recognizing a temporary change in worldwide
competitive conditions permits management to
make changes in operating strategies
11-15
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Diversifying Financing
• Diversifying the financing base means raising
funds in more than one capital market and in
more than one currency
• If a firm is diversified, management is
prepositioned to take advantage of temporary
deviations from the International Fisher effect
11-16
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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 currency
exposures
• Six of the most commonly employed proactive
policies are
–
–
–
–
–
–
11-17
Matching currency cash flows
Risk-sharing agreements
Back-to-back or parallel loans
Currency swaps
Leads and lags
Reinvoicing centers
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Matching Currency Cash Flows
• One way to offset an anticipated continuous long
exposure to a particular currency is to acquire
debt denominated in that currency
• This policy results in a continuous receipt of
payment and a continuous outflow in the same
currency
• This can sometimes occur through the conduct of
regular operations and is referred to as a natural
hedge
11-18
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Exhibit 11.5 Trident Europe’s Changing
Cash Flows under Euro Depreciation
11-19
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Exhibit 11.6 Debt Financing as a
Financial Hedge
11-20
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Currency Clauses: Risk-sharing
• Risk-sharing is a contractual arrangement in which
the buyer and seller agree to “share” or split
currency movement impacts on payments
– Example: Ford purchases from Mazda in Japanese yen at
the current spot rate as long as the spot rate is between
¥115/$ and ¥125/$.
– If the spot rate falls outside of this range, Ford and Mazda
will share the difference equally
– If on the date of invoice, the spot rate is ¥110/$, then
Mazda would agree to accept a total payment which
would result from the difference of ¥115/$- ¥110/$
(i.e. ¥5)
11-21
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Currency Clauses: Risk-sharing
• Ford’s payment to Mazda would therefore be



 ¥25,000,00
¥25,000,00
0
0

 $222,222.22


¥5.00/$
¥112.50/$
 ¥115.00/$
2


• Note that this movement is in Ford’s favor,
however if the yen depreciated to ¥130/$ Mazda
would be the beneficiary of the risk-sharing
agreement
11-22
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Back-to-Back Loans
• A back-to-back loan, also referred to as a parallel
loan or credit swap, occurs when two firms in
different countries arrange to borrow each other’s
currency for a specific period of time
– The operation is conducted outside the FOREX markets,
although spot quotes may be used
– This swap creates a covered hedge against exchange
loss, since each company, on its own books, borrows the
same currency it repays
11-23
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Cross-Currency Swaps
• Cross-Currency swaps resemble back-to-back
loans except that it does not appear on a firm’s
balance sheet
• In a currency swap, a dealer and a firm agree to
exchange an equivalent amount of two different
currencies for a specified period of time
– Currency swaps can be negotiated for a wide range of
maturities
• A typical currency swap requires two firms to
borrow funds in the markets and currencies in
which they are best known or get the best rates
11-24
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Cross-Currency Swaps
• For example, a Japanese firm exporting to the US
wanted to construct a matching cash flow swap, it would
need US dollar denominated debt
• But if the costs were too great, then it could seek out a
US firm who exports to Japan and wanted to construct
the same swap
• The US firm would borrow in dollars and the Japanese
firm would borrow in yen
• The swap-dealer would then construct the swap so that
the US firm would end up “paying yen” and “receiving
dollars” be “paying dollars” and “receiving yen”
• This is also called a cross-currency swap
11-25
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Exhibit 11.8 Using Cross Currency
Swaps
11-26
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Contractual Approaches
• Some MNEs now attempt to hedge their operating
exposure with contractual strategies
• These firms have undertaken long-term currency option
positions hedges designed to offset lost earnings from
adverse changes in exchange rates
• The ability to hedge the “unhedgeable” is dependent upon
predictability
– Predictability of the firm’s future cash flows
– Predictability of the firm’s competitor responses to
exchange rate changes
• Few in practice feel capable of accurately predicting
competitor response, yet some firms employ this strategy
11-27
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Summary of Learning Objectives
• Foreign exchange exposure is a measure of the potential for
a firm’s profitability, cash flow, and market value to change
because of a change in exchange rates. The three main
types of foreign exchange risk are operating, transaction,
and translation exposures.
• Operating exposure measures the change in value of the
firm that results from changes in future operating cash flows
caused by an unexpected change in exchange rates
• Operating strategies for the management of operating
exposures emphasize the structuring of firm operations in
order to create matching streams of cash flows by currency:
this is termed matching
11-28
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Summary of Learning Objectives
• An unexpected change in exchange rates impacts a firm’s
expected cash flow at four levels: 1) short run; 2) medium
run, equilibrium case; 3) medium run, disequilibrium case;
and 4) long run.
• Operating strategies for the management of operating
exposure emphasize the structuring of firm operations in
order to create matching streams of cash flows by
currency.This is termed natural hedging.
• The objective of operating exposure management is to
anticipate and influence the effect of unexpected changes in
exchange rates on a firm’s future cash flows, rather than
being forced into passive reaction
11-29
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Summary of Learning Objectives
• Proactive policies include matching currency of cash flow,
currency risk sharing clauses, back-to-back loans, and cross
currency swaps
• Contractual approaches have occasionally been used to
hedge operating exposure but are costly and possibly
ineffectual
• Strategies to change financing policies include matching
currency cash flows, back-to-back loans and currency swaps
11-30
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