Managing Economic/ Operating Exposure
International Corporate Finance
P.V. Viswanath
For use with Alan Shapiro “Multinational
Financial Management”
Learning Objectives
 To define economic exposure and exchange risk and
distinguish between the two
 To identify the basic factors that determine the forex risk
faced by a particular company or project.
 To calculate economic exposure given a particular exchange
rate change and cost/revenue scenarios
 To describe marketing, production & financial strategies
appropriate for coping w/ econ exposure.
 Contingency plans to cope with forex risk.
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Operating Exposure
 Operating Exposure is the firm’s uncertainty with
respect to its future operating cash flows.
 If PV = present value of a firm, then the firm is
exposed to currency risk if ΔPV/Δe  0.
 Operating exposure derives from the operating
analysis; hence planning for operating exposure
involves the interaction of strategies in finance,
marketing, purchasing and production.
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Real Exchange Rates and Exposure
 Currency changes are usually preceded by/accompanied by changes in
relative price levels, which can offset the impact of the currency change.
 Hence, it is impossible to determine exposure to a given currency
change without considering simultaneously the offsetting effects of these
price changes.
 If relative prices remain constant and the law of one price holds, then the
rate of change in the exchange rate equals the difference in inflation
rates between the two countries. That is, the real exchange rate is
constant, and PPP holds.
 The firm’s foreign cash flows will vary with the foreign rate of inflation.
 The exchange rate also depends on the differential rates of inflation; the
movement of the exchange rate will cancel out the effect of the change
in the foreign price level. Real dollar cashflows will be unaffected.
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Contracts fixed in foreign currency
 If the firm has contracts fixed in foreign currency terms,
it will be affected by exchange rate risk even if relative
prices are unaffected and PPP holds.
 Examples are debt with fixed interest rates, long-term
leases, labor contracts and rent.
 However, if real exchange rates do not change, what we
see here is really inflation risk and not forex risk. That
is, the same effect can occur domestically, as well.
 If contracts are indexed and if the real exchange rate
remains constant, forex risk is eliminated.
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Effects of Real Exchange Rate Changes
 A decline in the real value of a nation’s currency makes its
exports and import-competing products more competitive.
 E.g. if Brazil’s inflation rate stays high, but its exchange rate stays
constant, the real exchange rate will be rising and its products will
be at a competitive disadvantage.
 Hence there could be exchange risk even without changes in
nominal rates.
 An increase in the real value of a currency acts as a tax on imports
and a subsidy for exports.
 If the domestic production cost of a product rises, but exchange
rates remain the same, its cost in foreign currency will rise and it
will be disadvantaged relative to producers in other countries
whose costs have not gone up. Hence the correlation between
domestic production costs and exchange rates is important.
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Real Exchange Rate Changes
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Operating Exposure
 In evaluating the impact of an exchange rate change on the
firm, we cannot assume that local currency cost and revenue
streams remain constant.
 Measuring the likely exchange gain (loss) by multiplying the
pre-devaluation (pre-revaluation) local currency cashflows
by the projected devaluation (revaluation) will usually lead
to upwardly biased numbers.
 This is partly because inflation and exchange rate changes
are related, as shown by PPP.
 Also, the firm itself, its competitors and customers have
flexibility in terms of the decisions that they make.
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Pricing Flexibility
 The key issue for a domestic firm, when the dollar
appreciates is its pricing flexibility.
 Can it maintain its dollar margins both at home and
abroad?
 Can it maintain its dollar price on domestic sales in
the face of lower-priced foreign imports?
 In the case of foreign sales, can the firm raise its
foreign currency selling price to preserve its dollar
profit margin?
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Price Elasticity of Demand
 The less price elastic the demand for the company’s
products, the more price flexibility the company has.
 Price elasticity depends on the degree of competition and the
location of key competitors.
 The more differentiated a company’s products are, the less
competition it will face. (e.g. Mercedes Benz cars)
 If most competitors are based in the home country, then all
will face the same change in their cost structure, and no one
producer will be at a disadvantage vis-à-vis any other
domestic producer.
 Commodity exporters are very vulnerable to real exchange
effects because of the non-differentiated nature of their
products.
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More about Flexibility
 The firm’s susceptibility to exchange rate risk depends also
on its ability to shift production and the sourcing of inputs
among countries.
 A foreign subsidiary selling goods in its local market cannot
increase local prices enough to make up for a local currency
devaluation. However,


the devaluation will also help in fending off import competition.
the dollar value of local production costs will drop; however, the
higher the import content of local inputs, the less dollar production
costs will decline.
 if the firm can substitute local inputs for imported inputs, it
can cope better with the devaluation.
 if the firm can sell in other markets, it can keep dollar
revenues high.
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Explaining Exhibit 11.5
 Let the home country of the MNC be A, B is the country where
the goods are produced, either for local sales in B or for export
to C (or A itself). (Re)Devaluation occurs in country B.
 Row 1 (Revenue/Export Sales) refers to production in B for
sale in C. If B’s currency is devalued, the good can be sold at a
cheaper price in C and this will increase revenue in terms of A’s
currency.
 Row 2 (Revenue/Local Sales): if there is weak prior import
competition, then local prices will not be affected and hence the
revenue in terms of A’s currency will drop.
 Row 4 (Costs/Domestic inputs): if import content is low, then
dollar denominated costs are going to drop, since costs are
constant in terms of B’s currency.
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What affects Exchange Rate Risk?
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Operating and Financing Cash Flows
 Operating Cash flows arise from receivables and
payables, rent and lease payments for the use of
facilities and equipment, royalty and license fees
for the use of technology and intellectual property
and assorted management fees for services
provided.
 Financing Cash flows are payments for the use of
loans (principal and interest), and stockholder
equity (new equity investments and dividends).
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Intracompany MNE Operating and
Financing Cash Flows
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Operating Exposure
 Expected foreign exchange rate changes are not relevant for
the definition of operating exposure because management
and investors should have already factored this information
into their evaluation of anticipated operating results and
market value.
 For example, the forward rate might be used as a the future
spot rate estimate in preparing operating budgets.
 Similarly, expected cash flow to amortize debt should
already reflect the international Fisher effect. The level of
expected interest and principal payments should be a
function of expected exchange rates, rather than existing
rates.
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Factors Affecting Operating Exposure:
An Example
 Operating exposure is not restricted to foreign exchange
exposure.
 Example: Volvo’s operating exposure can be traced to:



Swedish Krona/DM Exchange Rate uncertainty
The uncertainty of future Swedish Krona short-term interest
rates (which is related to the demand for cars).
German producer price uncertainty
 Still, exchange rate uncertainty is very important and is
characteristic of the operating exposure of global firms.
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Operating Exposure: Short Run Impact
 The first level impact is on the one-year operating
budget; the gain or less depends on the currency of
denomination of expected cash flows
 In the short run, it is difficult to change the
exposure due to implied obligations, such as
purchase or sales commitments, because the
currency of denomination cannot be changed.
 It is also difficult to change sales prices or to
renegotiate factor costs
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Operating Exposure: Medium Run –
Parity Conditions Hold
 The second level impact is on expected medium-term cash
flows.
 If parity conditions hold, the firm should be able to adjust
prices and factor costs over time to maintain the expected
level of cash flows, if no real variables have changed.
 The country of cash flow origination and its monetary,
fiscal, and balance of payments policies will determine
whether firms can adjust prices and costs.
 Example: If Volvo is selling cars to Germany and the DM
depreciates because the German money supply rises, Volvo
will be protected if it can raise its DM prices, so that the
Krona price is maintained.
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Operating Exposure: Medium Run –
Change in Real Variables
 If the firm is not able to adjust prices and costs because the
change in exchange rates has been accompanied by real
changes, so that relative prices have been altered.
 Example: If the DM has depreciated relative to the Krona
because German investors have lost confidence in the
German economy and are moving their capital to Sweden,
the wealth of German investors has dropped, the real price
of a Swedish car has risen and Volvo may not be able to
raise its prices proportionately. There is less than perfect
pass-through.
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Operating Exposure: Long Run
 Long-run cash flows beyond five years could be
affected. Cash flows will be influenced by the
reactions of existing and potential competitors to
exchange rate changes when real variables are
affected.
 In principle, all firms subject to international
competition, domestic or multinational, are subject
to foreign exchange operating exposure in the long
run, whenever real variables are affected.
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Instruments du Rhone – 1
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Instruments du Rhone -- 2
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Managing Operating Exposure
Strategically – Diversifying Operations
 The key to operating exposure management is to anticipate
and influence the effect of unexpected changes in exchange
rates on a firm’s future cash flows.
 Management can diversify the firm’s operating and
financing base.
 Diversifying operations means diversifying sales, location of
production facilities and raw material sources.
 Diversifying financing means raising funds in more than one
capital market and in more than one currency.
 It can change the firm’s operating and financing policies.
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Strategic Diversification of Operations
 There might be a change in comparative costs in the firms’
own plants located in different countries.
 Management can make marginal shifts in sourcing raw
materials, components, or finished products. If spare
capacity exists, production runs can be lengthened in one
country and reduced in another.
 There might be a change in profit margins or sales volume in
one area compared to another, depending on price and
income elasticities of demand and competitor’s reactions.
 Marketing efforts can be strengthened in export markets
where the firms’ products have become more pricecompetitive.
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Managing Operating Exposure –
Diversifying Financing
 Interest rates differentials might not adjust fully to expected
changes in interest rates.
 In this case, provided the firm is established and known in
different markets, it can change the source of its short and
long-term financing.
 Diversifying financing per se can also help diversify risks of
restrictive capital market policies or government borrowing
competition in the capital market
 It can help diversify political risks – expropriation, war,
blocked funds, or unfavorable changes in laws.
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Changing Operating Policies – Leads
and Lags
 Firms can reduce transaction and operating risk by
accelerating (lead) or decelerating (lag) the timing
of payments. This will depend on expected changes
in exchange rates.
 Firms can also try to accelerate or decelerate the
collection of receivables, for the same reason, and
in the same way.
 Suppliers/Clients may not want to go along. This
may require incentive payments.
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Intracompany Leads and Lags
 Leading and lagging between related firms is more feasible.
 When done between subsidiaries, it has the effect of an
intracompany loan and represents an alternative way of
shifting capital, that is less subject to government
interference.
 However, it is unfair if each unit has minority stockholders
separate from the corporate family, since leading/lagging
will affect the relative rate of return of the different units.
 Widespread leading/lagging can affect exchange rates.
Hence, governments that want to affect exchange rates may
put limits on lagging.
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Intracompany leads and lags
 Suppose a multinational company faces the following aftertax borrowing and lending rates:
US
Germany
Borrowing Rate
3.8%
3.6%
Lending Rate
2.9%
2.7%
 If the US unit requires funds and the German unit has excess
funds, then leading funds owed by the German unit to the
US unit or lagging funds owed by the US unit to the German
unit has the effect of a loan by the German unit to the US
unit with a saving of 110 basis points.
 If both units have excess funds, it would be profitable to
move funds to the US, with an interest differential of 20
basis points (2.9 versus 2.7).
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Risk Sharing
 Risk-Sharing is a contractual arrangement in which the
buyer and seller agree to share or split currency movement
impacts on payments that pass between them.
 This is worthwhile if the relationship between the two firms
is long-term.
 For example, Ford and Mazda may agree that all purchases
by Ford will be made in Japanese yen at the current rate, as
long as it is between 115 and 125 yen/$.
 If the rate falls outside this range, they may agree to share
the difference equally.
 Of course, if the equilibrium rate level changes drastically,
the agreement will have to be changed.
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Reinvoicing Centers
 A reinvoicing center is a separate corporate subsidiary that
manages in one location all transaction exposure from
intracompany trade.
 Effectively, the reinvoicing center centralizes transaction
exposure risk, and diversifies the exposure of the parent
company to transaction exposure. It need only hedge
residual exposure risk.
 This method releases individual company subsidiaries from
having to worry about transaction exposure for
intracompany trades.
 The reinvoicing center can manage intra-affiliate cash flows,
including leads and lags of payments.
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Reinvoicing Centers
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Modifying Financing Policies –
Natural Hedges
 One way to offset an anticipate continuous long exposure to
a particular currency is to acquire debt denominated in that
currency.
 If stable (in foreign currency) and continuing receipts from
sales are expected, debt in the foreign currency could be
issued; the sales receipts would be used to make interest
payments on the debt. This is a form of matching.
 The firm could also seek raw material suppliers in Canada,
so that sales receipts could be used to pay for purchases.
 The firm could arrange to pay raw material suppliers from a
third country using the foreign currency of the sales receipts.
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Natural Hedges – An Example
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Back to Back Loans
 Also known as a parallel loan or credit swap.
 Two firms in separate countries agree to borrow each other’s
currency for a specified period of time. At an agreed
terminal date, they return the borrowed currencies.
 Principal parity might be required – akin to marking to
market.
 The advantage is that there is no foreign exchange risk, and
it doesn’t require the approval of any government body
regulating the use of foreign exchange.
 However, a counterparty must be found for the currency,
amount and timing desired.
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Back to Back Loans
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Currency Swaps
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Currency Swaps
 Accountants in the US treat currency swaps as
foreign exchange transactions rather than as debt
and treat the obligation to reverse the swap at some
later date as a forward exchange contract.
 Forward exchange contracts can be matched against
assets, but they are entered in a firms’ footnotes
rather than as balance sheet items. Hence, both
accounting and operating exposures are avoided.
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Contractual Hedging and Long-term
Exposure
 Normally, firms take contractual positions like forward contracts
and options in order to hedge positions that do not have quantity
risk (but only exchange rate risk), such as hedging transaction
exposure.
 However, firms that have relatively predictable cash flows might
use contractual strategies to hedge operating exposure as well. This
is usually difficult because it is necessary for the firm to be able to
predict competitor response as well.
 Another question with contractual hedging to protect against
changes in strategic position is that it is purely a short-term hedge.
A change in strategic posture would be a longer-term response.
 Hence contractual hedging would be effective only if the “strategic”
impacts are temporary.
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