Chapter 12

Chapter 12
Operating Exposure
Operating exposure, (also called economic
exposure, competitive exposure, and strategic
measures the change in the firm´s present
resulting from the changes in future operating
cash flows caused by an unexpected change in
exchange rates.
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.
To analyze the longer term exchange rate
changes that are unexpected and its impact
on the firm– is the goal of operating
exposure analysis.
Differentiating cash flows of MNEs:
Operating cash flows arise
from business activities: that
is, 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 management fees.
Financing cash flows are from financing activities, that is
payments for loans (principal and interest), equity
injections and dividends.
Operating exposure is important for the long-run health
of a business.
However, 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 management
responsibility because it relates to the interaction of
strategies in finance, marketing, purchasing and
An expected change in foreign exchange rates
is not included in the definition of operating
From an investor’s perspective, if the foreign
exchange market is efficient, information
about expected changes in exchange rates
should be reflected in a firm’s market value.
Only unexpected changes in exchange rates,
or an inefficient foreign exchange market,
should cause market value to change.
We discuss the dilemma facing Trident as a
result of an unexpected change in the value
of the euro, €, the currency of denomination
for Trident´s German subsidiary.
There is concern over how the subsidiary´s
revenues (price and volumes in euro terms),
costs (input costs in euro terms), and
competitive landscape will change with a fall
in the value of the euro.
Trident Europe:
 Case 1: Euro Devaluation €, no change in any
 Case 2: Increase in sales volume; other variables
remain constant.
 Case 3: Increase in sales price; other variables
remain constant.
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.
Management team is prepositioned both to
recognize disequilibrium when it occurs and to
react competitively if the firm´s operations are
diversified internationally .
Recognizing a temporary change in worldwide
competitive conditions permits management to
make changes in operating strategies.
Domestic firms do not have the option to react in
the same manner as an MNE.
If a firm’s financing sources are diversified, it
will be prepositioned to take advantage of
temporary deviations from the international
Fisher effect. i$ –i€ =PUS -PEU
However, to switch financing sources from
one capital market to another, a firm must
have the ability to operate in the
international investment community.
Again, this would not be an option for a
domestic firm.
Operating and transaction exposures can be partially
managed by adopting operating or financing policies that
offset anticipated foreign exchange exposures.
The six most commonly employed proactive policies are:
Matching currency cash flows
Risk-sharing agreements
Back-to-back ( parallel loans), or credit swaps.
Currency swaps
Leads and lags
Reinvoicing center
Example: a US firm has a 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 series of transaction exposures could be continually
hedged with forwards, futures or options, etc.
Or using operating exposure management methods
described as follows:
 One way to offset an anticipated continuous long
exposure to a particular company is to acquire
debt denominated in that currency (matching).
 Alternatively, the US firm could seek out potential
suppliers of raw materials or components in
Canada as a substitute for US and other foreign
 In addition, the company could engage in currency
switching, in which the company would pay
foreign suppliers with Canadian dollars.
Currency Risk-Sharing:
 a method to manage a long-term cash flow
 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.
Risk Sharing Agreement between Mazda and
Ford agrees to pay all purchases in Japanese
Yen to Mazda as long as the spot exchange rate
on the day of invoice is between 115 yen/$ to
125 yen/$. If however the exchange rate falls out
of this range, Mazda and Ford will share the
difference equally.
What happens if the rate falls to 110 yen/$?
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 foreign currency
for a specific period of time, but totally circumvent
the foreign exchange market . See the following
 At an agreed terminal date they return the borrowed
 Such a swap creates a covered hedge against
exchange loss, since each company, on its own books,
borrows the same currency it repays.
There are risks involved in the widespread use
of the back-to-back loan:
1. It is difficult for a firm to find a partner, termed a
counterparty for the currency amount and timing
2. 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).
Currency Swaps:
 A currency swap resembles a back-to-back loan
except that it does not appear on a firm’s balance
 In a currency swap, a firm and a swap dealer or
swap bank agree to exchange an equivalent
amount of two different currencies for a specified
amount of time.
Leads and Lags: Re-timing the transfer of funds
 Firms can reduce both operating and transaction exposure 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
 Intercompany leads and lags requires the time preference of one
independent firm to be imposed on another.
Reinvoicing Centers: There are three basic
benefits arising from the creation of a
reinvoicing center:
 Managing foreign exchange exposure
 Guaranteeing the exchange rate for future orders
 Managing intrasubsidiary cash flows
Some MNEs now attempt to hedge their operating exposure
with contractual hedges.
Merck and Eastman Kodak have undertaken long-term
currency option positions hedges designed to offset lost
earnings from adverse exchange rate changes.
The ability to hedge the “unhedgeable” is dependent upon:
 Predictability of the firm’s future cash flows
 Predictability of the firm’s competitor’s responses to exchange rate
Why do you think Toyota waited so long to move much of its
manufacturing for European sales to Europe?
 If Britain were to join the European Monetary Union, would the
problem be resolved? How likely do you think it is that Britain will
 If you were Mr. Shuhei, how would you categorize your problems and
solutions? What was a short-term and what was a long-term
 What measures would you recommend Toyota Europe take to resolve
the continuing operating losses?