Managing Economic Exposure-New Chapter 11

Measuring and managing economic exposure
Economic Exposure: based on the extent to which the value of the firm --- as measured
by the present value of its expected future cash flows --- will change when exchange rates
change.
Two components: Transaction Exposure and Operating Exposure.
Transaction exposure: exchange gains or losses on foreign currency-denominated
contractual obligations (short term).
Transaction exposure arises out of the various types of transactions that require
settlement in a foreign currency. Such as borrowing and lending in foreign currencies, the
local purchasing and sales activities of foreign subsidiaries, lease payment, forward
contracts, loan repayment and other contractual or anticipated foreign currency receipts
and disbursements.
Operating exposure: the future gains or losses on revenues and costs because of real
exchange rate changes (long term).
Operating exposure (long term)
Demand Side
[revenue]
Price
Volume
[Price elasticity of Demand]
Managing operating exposure:
1.
2.
3.
4.
5.
Market selection
Payoff between price and volume
Product innovation.
Global purchasing and production.
Financial management: hedging.
Supply Side
[cost]
Domestic Input Foreign Input
[Substitution of Costs]
Case: Rolls-Royce Limited

Rolls-Royce Limited, the British aeroengine manufacturer, suffered a loss of 58
million in 1979 on worldwide sales of 848 million. The companys annual report for
1979 blamed the loss on the dramatic revaluation of the pound sterling against the dollar,
from 1=$1.71 in early 1977 to 1= $2.12 by the end of 1979.
The most important reason for the loss was the effect of the continued weakness of
the U.S. dollar against sterling. The large civil engines that Rolls-Royce produces are
supplied to American air frames. Because of U.S. dominance in civil aviation, both as
producer and customer, these engines are usually priced in U.S. dollars and escalated
accordingly to U.S. indices.
A closer look at Rolls-Royces competitive position in the global market for jet
engines reveals the position in the global market for jet engines reveals the sources of its
dollar exposure. For the previous several years Rolls-Royces export sales had accounted
for a stable 40% of total sales and had been directed at the U.S. market. This market is
dominated by two U.S. competitors, Pratt and Whitney Aircraft Group (United
Technologies) and General Electrics aerospace division. As the clients of its mainstay
engine, the RB 211, were U.S. aircraft manufacturers (Boeings 747 SP and 747,00 and
lock-heeds L1011), Rolls-Royce had little choice in the currency denomination of its
export sales but to use the dollar.
Indeed, Rolls Royce won some huge engine contracts in 1978 and 1979 that
were fixed in dollar terms. Rolls-Royces operating costs, on the other hand, were almost
exclusively incurred in sterling (wages, components, and debt servicing). There contracts
were mostly pegged to an exchange rate of about $1.80 for the pound, and Rolls-Royce
officials, in fact, expected the pound to fall further to $1.65. Hence, they didnt cover
their dollar exposures. If the officials were correct, and the dollar strengthened, RollsRoyce would enjoy windfall profits. When the dollar weakened instead, the combined
effect of fixed dollar revenues and sterling costs resulted in foreign exchange losses in
1979 on its U.S. engine contracts that were estimated by The Wall Street Journal (March
11, 1980, P.6) to be equivalent to as much as $200 million.
Moreover, according to that same Wall Street Journal article, the more engines
produced and sold under the previously negotiated contracts, the greater Rolls-Royces
losses will be.
Questions
1. Describe the factors you would need to know the assess the economic impact on
Rolls-Royce of the change in the dollar: sterling exchange rate. Does inflation
affect Rolls-Royces exposure?
2. Given these factors, how would you calculate Rolls-Royces economic exposure?
3. Suppose Rolls-Royce had hedged its dollar contracts. Would it now be facing any
economic exposure? How about inflation risk?
4. What alternative financial management strategies might Rolls-Royce have flowed
that would have reduced or eliminated its economic exposure on the U.S. engine
contracts?
5. What nonfinancial tactics might Rolls-Royce now initiate to reduce its exposure
on the remaining engines to be supplied under the contracts? On future business
(e.g., diversification of export sales)?
6. What additional information would you require to ascertain the validity of the
statement that the more engines produced and sold under the previously
negotiated contracts, the greater Rolls-Royces losses will be?
Case: Laker Airways

The crash of Sir Freddie Lakers Skytrain had little to do with the failure of its
navigational equipment or its landing gear; indeed, it can largely be attributed to
misguided management decisions. Lakers management erred in selecting the
financing mode for the acquisition of the aircraft fleet that would accommodate
the booming transatlantic business spearheaded by Sir Freddies sound concept
of a no-frill, low-fare, stand-by air travel package.
In 1981, Laker was a highly leveraged firm with a debt of more than $400 million.
The debt resulted from the mortgage financing provided by the U.S. Eximbank and the
U.S. aircraft manufacturer McDonnell Douglas. As most major airlines do, Laker
Airways incurred three major categories of cost: (1) fuel, typically paid for in U.S. dollars
(even though the United Kingdom is more than self-sufficient in oil); (2) operating costs
incurred in sterling (administrative expenses and salaries), but with a nonnegligible dollar
cost component (advertising and booking in the United States); and (3) financing costs
from the purchase of U.S.-made aircraft, denominated in dollars. Revenues accruing from
the sale of transatlantic airfare were about evenly divided between sterling and dollars.
The dollar fares, however, were based on the assumption of a rate of $2.25 to the pound.
The imbalance in the currency denomination of cash flows (dollar-denominated cash
outflows far exceeding dollar-denominated cash inflows) left Laker vulnerable to a
sterling depreciation below the budgeted exchange rate of 1=$2.25. indeed, the dramatic
plunge of the exchange rate to 1=$1.6 over the 1981-1982 period brought Laker
Airways to default.
Could Laker have hedged its natural dollar liability exposure? The first option of
indexing the sale of sterling airfare to the day-to-day exchange rate was not a viable
alternative. Advertisements, based on a set sterling fare, would have had to be revised
almost daily and would have discouraged the price-elastic, budget-conscious clientele
of the company. Another possibility would have been for Laker to direct more of its
marketing efforts toward American travelers, thereby giving it a more diversified demand
structure, when the pound devalued against the dollar, fewer British tourists would
vacation in the United States, but more Americans would travel to Britain. Laker could
also have financed the acquisition of DC 10 aircraft in sterling rather than in dollars,
thereby more closely matching its pound outflows with its pound inflows. This example
points out that the currency denomination of debt financing can ill afford to be
determined apart from the currency risk faced by the firms total business portfolio.

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What factors would Rolls-Royce need to consider to assess the economic impact of the change in the dollar-sterling exchange rate? Does inflation affect Rolls-Royce’s exposure?

Given the factors that affect Rolls-Royce's exposure, how would you calculate Rolls-Royce’s economic exposure?

Measuring and managing economic exposure

Case: Rolls-Royce Limited

Case: Laker Airways

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