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